In the news this week
- Donald Trump doubles down on the US-China trade war
- Boris Johnson makes the no-deal Brexit threat all too real for the EU
- Shinzo Abe disrupts global tech sector supply chains be removing South Korea from a list of preferred trading partners
Market Sentiment Summary
- Most markets swing from neutral or mildly positive, to moderately negative on escalating trifecta of geopolitical risks.
- Some markets are being supported by projected accommodative central banks (US, China, Europe). Some by declining currencies (UK).
- Factor contribution to the change in scores confirms traditional move to safety with preference for high dividend-paying, profitable, low volatility, low beta, stocks, but noticeable absentees from that list include Size, Value, Growth, and Leverage, indicating that investors clearly expect central banks to bail them out once again.
US market sentiment Returns to risk-off position, but not as much as expected
In the last week, US investors have been under a trifecta of negative geopolitical events. First there was the escalation in the US-China trade war when president Trump announced fresh tariffs on $300 billion of additional Chinese imports – some of which will directly impact US consumers. Yet Axioma’s ROOFTM Score for the US market ‘only’ went from a mildly positive 1.1 to a moderately negative -1.9. By contrast, in May when the market was faced with a similar escalation in trade tension as the US pulled out of talks with China, the ROOF Score for the US market went from a neutral 0.2 to a very bearish -5.2 (a 1.8 st.dev. event). Surely three negatives is worse than one, what changed this time around? Two things.
First, in May investors thought a trade deal was imminent (i.e. momentum on the deal was seen as having gone form positive to negative), not this time (i.e. momentum is seen as having gone from neutral (at best) to negative). Second, Back in May investors expected no further Fed Rate hikes this year, but no cuts either. Today, the Fed has already cut once and another 0.25 bps cut is expected, but this news (and other globally escalating conflicts around Brexit and Japan-South Korea) is increasing the likelihood of further rate cuts. Back in May, the decomposition of the ROOF score for the US market showed that investors moved out of highly leveraged, low dividend-paying, volatile, high-beta, small-cap growth companies into profitable, cashflow-positive, high-dividend paying, large-cap, low volatility and low beta stocks. Today they maintained their small cap, growth, and leverage exposures, indicating that the new consensus on rate cuts is factoring into their decision.
Second, the bearish ROOF scores in May were related to a single geopolitical negative, the US-China trade war, today we have three. The US-China trade war threatens both the largest and second largest economies in the world, Brexit threatens the largest trading block in the world, and the Japan-South Korea spat threatens the tech sector’s global supply chain. Investors now clearly see the handling of these crisis by Donald Trump, Boris Johnson, and Shinzo Abe as three distinct risk factors on their own. Yet, back in May when only one of those crisis was acting on investor sentiment, the contribution to the overall ROOF Score for the US market was nine-to-one in favor of risk-aversion (only the negative Value factor returns remained as a contributor to risk-tolerance), but this week, the balance in favor of risk-aversion is only six-to-four with traditional risk-on factors such as (negative) Size, Leverage, and Growth remaining in investors portfolios.
ROOF Score for United States – All Caps From: 1/2/2019 to 8/2/2019
Metric Contribution to Daily Risk Tolerance Score
Metric Contribution to Daily Risk Aversion Score
So, where does that leave us? Variations in the ROOF Scores have been getting smaller and smaller since the end of Q1 2019, mostly on the back of declining risk-tolerance scores while risk-aversion remained in check. This leads us to believe that investors were hedging their equity risk with other asset classes (i.e. US treasuries) rather than adopting a full-on risk-off strategy in their portfolios (i.e. they kept their bets on growth, small caps, and leverage). As consensus built on the direction of US interest rates, investors seem to have chosen to see these cuts as the Fed becoming more accommodative towards growth, and not as a rescue mission ahead of an impending recession (i.e. no need to panic, the Fed will grease the wheels and the economic growth engine will restart). To be fair, (backward-looking) fundamental economic data in the US still points to a healthy economy, although corporate earnings and forward guidance from CEOs, as well the recent rise in corporate bond spreads, are starting to raise some doubts.
The remaining bets on growth, small-caps, and leverage, all need an acceleration in economic growth to pay off. As long as investors hold on to hopes that central banks can indeed restart global growth on their own or with the help of political resolutions to the current conflicts, these factors will remain supportive of risk-tolerance, but if investors change their minds about the ability of monetary policy to effectively counteract bad leadership, then risk-aversion will gain momentum as investors reverse these bets and risk assets will experience a large supply-demand imbalance for some time.
How long depends on how much risky assets investors still hold, but given the recent drop in Treasury yields which has seen the tapering-induced rise of the last two years erased in just six months, we may not be far from equilibrium.
Axioma’s ROOF™ Scores Explained – The ROOF Scores were created to quantify market sentiment—in other words, bullish or bearish? ROOF is an acronym for Risk-On/Risk-Off market conditions. ROOF Scores are calculated from the factor returns to eight style factors from Axioma’s short-horizon fundamental factor risk models, plus two indicators of changing market volatility. Together, these 10 metrics are used to compute risk-tolerance and risk-aversion scores. To quantify the overall market sentiment, we simply take the difference between the two (risk-tolerance minus risk-aversion).