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ROOF Highlights — December 11, 2023

Axioma ROOF™ Score Highlights: Week of December 11, 2023

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Potential triggers for sentiment-driven market moves this week1:

  • US: Fed’s interest rate decision, CPI, PPI, and retail sales data.
  • Europe: ECB and BoE interest rate decisions, UK unemployment data, and German economic sentiment index.
  • APAC: Japan’s manufacturer’s tankan index. China’s house price index, industrial production, retail sales, and unemployment (all Friday).
  • Global: Any security fallout from the resumption of the Israel-Hamas war.

Insights from last week’s changes in investor sentiment:

Investor sentiment improved further last week in all markets we track, except China, where sentiment declined (very) rapidly from bullish to neutral. This week is theoretically a big one for markets, with monetary policy decisions across several major central banks (Fed, ECB, and BoE). In practice, however, investors are almost certain of a ‘no-change’ decision and have already priced that in (and maybe a little extra) during the November rallies. Investors, who increasingly believe they are on the ‘Good’ list this year, will focus on the language of the press releases, as well as next week’s meeting minutes, looking for clues on the timing of the first (of many?) rate cuts of 2024.

The Chinese economy fell further into deflation last month, with CPI declining by 0.5% (much more than anticipated), and PPI by 3% (its 14th consecutive monthly decline). The lack of response from the authorities was unexpected (not to mention disappointing). The response from investors, however, was as expected: First, shock, then surprise, then Whiskey Tango Foxtrot (!). Prior to last week, sentiment had been bullish since late October, with hopes for a big stimulus package. The plunge to neutral in a single week could signal that investors are throwing in the towel. In the absence of a detailed and credible response from the authorities, this negative momentum could turn the neutral sentiment into a bearish one, within this week.

Japan has been the best performing market year-to-date, rising almost 30%, yet sentiment has not been bullish for a single day in that market. In fact, out of the 231 trading days so far this year, Japanese investors were positive (i.e. hopeful) on only 18 (8%) days, neutral (i.e. undecided) on 112 (48%) days, negative (i.e. worried) on 64 (28%) days, and outright bearish (i.e. scared) on 37 (16%) days. This conundrum of a rising market, despite a mostly weak investor sentiment, is reminiscent of the situation in the US and Europe in 2021 when investors wanted to play the post-Covid reopening economic rebound story but were wary of the Fed and the ECB’s inaction in the face of rising inflation.

During that year, both markets rose but Risk-Off portfolios outperformed the Risk-On portfolios by a wide margin. In 2023, investors have been wanting to play the weak Japanese Yen and the supply chain relocation (out of China) stories but have been worried about the BoJ’s lack of action both in its monetary policy (inflation has been above target since April 2022) and currency market intervention (even when the USD/JPY crossed the 150-level last month). Sentiment remains positive, for now, but the BoJ’s inertia will increasingly weigh on investors’ mood going forward, and the market could well lose its weakening Yen support in 2024. Especially, if the interest rate differential between the US and Japan declines, causing investors to implement a strengthening Yen story instead.

Globally (ex-China and Japan), sentiment will continue to be supported by signs of an economic soft-landing, accompanied by hopes for more accommodative monetary policies by major central banks (to avoid a hard landing). Factors behind the improving sentiment include positive macro data, a peak in interest rates, and low volatility. Factors against include geopolitics (Ukraine and Israel), and the unpredictable state of domestic politics in the US and Europe. For now, investors seem happy to let the latter be next year’s problem. So, unless the Fed and the ECB reiterate this week that they remain serious about ‘higher-for-longer’, sentiment should continue to reflect investors’ anticipation for an early Christmas present.

Note: green background = bullish, red background = bearish

Changes to investor sentiment over the past 180 days for the markets we follow:

How to read these charts: The top charts show the ROOF ratio (investor sentiment) in green (left axis), against the cumulative returns of the underlying market in black (right axis). The horizontal red line at -0.5 (left axis) represents the frontier between a negative sentiment (-0.2 to -0.5) and a bearish one (<-0.5), and the horizontal blue line at +0.5 (left axis) represents the frontier between a positive sentiment (+0.2 to +0.5) and a bullish one (>+0.5). Around the horizontal grey line at 0.0 (left axis), sentiment can be considered neutral (-0.2 to +0.2).

The bottom charts show the levels of both risk tolerance (green line) and risk aversion (red line) in the market. These represent investors’ demand and supply for risk. When risk tolerance (green line) is higher than risk aversion (red line), there are more investors looking to buy risk assets then investors willing to sell them (at the current price), forcing risk-tolerant investors to offer a premium to entice more risk-averse counterparts to take the other side of their trade, which drives markets up. The reverse is true when risk aversion (red line) is higher than risk tolerance (green line). The net balance between risk tolerance and risk aversion levels is used to compute the ROOF ratio in the top charts, representing the sentiment of the average investor in the market.

The blue shaded zone between levels 3-4 for both indicators, represents a reasonable balance between the supply and demand for risk in the market. Conversely, when both lines are outside of this blue zone, the large imbalance in the demand and supply for risk can lead to an overreaction to unexpected news or risk events.

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Asia ex-Japan:

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1 If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.

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