ROOF Highlights — February 17, 2020

Qontigo ROOF™ Score Highlights: Week Beginning February 17, 2020

In the news this week: Minutes from the Federal Reserve, ECB, RBA and RBI, and rate decision in China. Flash PMI for the US, UK, Eurozone, Japan and Australia could provide an insight into the early impact of the coronavirus outbreak on the global economy. Also out this week, US housing data, UK jobs report, inflation and retail trade data, Japan Q4 GDP and trade balance, and Australia employment numbers.

Summary: For the second week in a row, investors have responded to the increased economic and earnings uncertainty from the continuing coronavirus outbreak by remaining in the neutral zone. Yet, you would not know this by looking at market returns which except for Japan (which overshot sentiment last week), were all positive. This is where this crisis differs from the SARS outbreak which pre-dated the decade-long QE programs and their resulting moral hazard. Today when a crisis hits, investors line-up around the block rolling-up their sleeves for an injection of easy credit by central banks instead of rationally adjusting their forecasts of return and de-risking their portfolios accordingly.

  • Globally, sentiment is remaining in the neutral zone. This means investors are neither bearish nor bullish at this point. This is in line with the continued uncertainty over when or how this global health crisis will end. Markets, however, are all up (except Japan which was strongly up the previous week)! How do we square that circle? The bond market offers a clue. Investors are speculating on another round of monetary easing from central banks. 
  • Volatility, while not high, is higher than in Q4.  Ditto for uncertainty. This translates into lower risk appetite. Yet, investors this past week had a penchant for large cap, high beta, volatile, growth stocks which is pushing index levels up to new highs.
  • The missing link between investor sentiment and market returns this past week is the expectation/speculation for lower interest rates. Without that, earning forecasts would have to be raised to make sense of valuations.

Sentiment in the US continued to decline this past week and crossed into negative territory (-0.1), albeit still in the neutral zone.  Markets, meanwhile, are defying sentiment by reaching daily new highs.

Markets had been in tune with sentiment since early November (see boxed period in below chart), but sentiment peaked in December then drifted sideways for the rest of the month while remaining in supportive (>+0.5) territory.  The coronavirus outbreak affected sentiment which accelerated its decent into neutral territory since January 10. Markets responded in kind dipping in late January.  Since the start of February, however, the US market has been at odds with investor sentiment in a dangerous game of chicken between greed and fear – two emotions you really don’t want to be playing this game with.

The divergence between market return and investor sentiment, together with current valuation levels, have downgraded the earnings needed to validate them, from rational forecasts to, well,  faith. The clarity about the fallouts from the corona virus that investors seek may not be a welcomed one (as today’s announcement from Apple suggests).  And, judging by the bond market, this newfound faith seems to be in the Fed. Since the GFC, investors have become addicted to easy credit and central bankers are their primary dealer. But, unless the Fed sees clear evidence that a more accommodative stance is needed to ward-off a sharp economic slowdown, it may not act, leaving speculators to deal with the fallouts from their buy-now-pay-later buying spree of the last two weeks.

Having said that, investor sentiment is neutral, not yet bearish, so they may not over-react to negative earnings news yet, but the best time to build the roof is always before the rain, never after.

Markets in Japan had dangerously overshot sentiment the previous week and after correcting for this divergence made another thwarted attempt at new high, but investor sentiment would not be supportive.

Japanese investors have become less bearish in the past week but are not yet supportive of any further attempts at new highs and remain firmly at the bottom of the neutral zone – dangerously close to becoming unsupportive again.  As with any crisis, investors are always just one news away from becoming bearish or bullish. After consecutive negative news that saw Japan become the second most corona virus affected country after China, sentiment had descended into unsupportive (<-0.5) territory.  The market briefly tried to ignore that sudden drop in risk appetite and staged a rally in Mid-January which quickly fizzled out of steam giving way to a correction in-line with investor sentiment.

Like most other markets, Japan staged a rally in the first week of February hoping that the worst of the crisis was over, only to find out it wasn’t. Sentiment has recovered somewhat since then but is nowhere near the supportive levels needed to stage a credible and sustainable attempt at new highs from here.  With sentiment this fragile and the upside potential seemingly limited by a low risk appetite, prudence may be the best strategy here. Risk-averse styles such as dividend yield, profitability, and value, have been neglected in this rally and may offer cheaper valuations than growth and leverage.

Markets in Asia ex-Japan have been broadly in tune with investor sentiment since early October but have diverged from it last week – in tandem with many others.

Markets in Asia ex-Japan have diligently followed investor sentiment until now. Last week’s rally extended a divergence between returns and investor sentiment that started the previous week. Like other markets it was founded on the hope that the worst of the corona virus outbreak was behind us, but new data last week showed a resurgence of new cases and the death toll has now exceeded that of SARS.  The economic and corporate fallouts are still to be evaluated.

This month will show the first wave of economic numbers for January – the first full month under the crisis, and investors will be reacting to those numbers by adjusting their own forecasts for both the near and medium terms (i.e. Q1 and CY 2020). Spoiler alert, these are unlikely to be upward revisions. HK was already in recession, Japan thought to be very close to one, and the rest of the region was slowing down under the weight of the trade war of the last two years.  Given this background, what gave markets the confidence to go for a 4% rally in the last two weeks? 

Taking a longer view, Asia ex-Japan markets have now rallied over 15% since early August 2019 so there are plenty of profits for the taking.  Until the ROOF Ratio stages a comeback to supportive territory (>0.5), it may be wise to help yourself to some. Having said that the daily ROOF Scores on which the ROOF ratios are based, did point to the start of a recovery in the last two days of last week.  Let’s see if they can carry this newfound optimism into this week.