ROOF Highlights — April 11, 2022

Qontigo ROOF™ Score Highlights: Week of April 11, 2022

Potential triggers for sentiment this week1 :

  • US: Earnings season kicks off (BlackRock and JPMorgan Chase report on Wednesday, while Citigroup, Goldman Sachs, Morgan Stanley and Wells Fargo do so on Thursday). CPI data on Tuesday is expected to show inflation hit 8.5% in March, the highest since December of 1981. Speeches from several Fed officials.
  • Europe: The ECB will deliver its latest monetary policy decision, but no changes are expected. In the UK, scheduled releases include monthly GDP data, industrial production, and jobs. UK March CPI is also expected and forecast to have surged by 6.7%, the most since 1992.
  • APAC: The spotlight will be on China, whose inflation rate, credit, and external trade figures for March are expected. Possible COVID-19 related lockdowns in China and Hong Kong.
  • Globally: The ongoing conflict in Ukraine and the response from the West will continue to dictate investor sentiment, as well as food prices globally.

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

Summary of changes in investor sentiment from the previous week:

  • Investor sentiment continued to improve last week in all markets we track, on the back of lower market risk. Investors in the US, global emerging markets, Japan and China all ended the week with a more neutral, albeit still negative, sentiment. Investors remain bearish only in developed Europe, global developed markets and Asia ex-Japan, where sentiment has recovered but not yet reached a neutral level.
  • Other than in the US and global emerging markets, however, the recovery in sentiment from declining market risk ahead of a holiday-shortened week and the start of the Q1 2022 earnings reporting season, was not mirrored by a more bullish sector allocation (red dotted lines in charts below). In fact, investors continue to implement a mostly risk-averse sector allocation in most markets, indicating they are still negative about the economic outlook.
  • After Deutsche Bank last week, several other investment banks are predicting a recession in the US economy because of the Fed’s hawkish stance towards inflation. Calls have already been made for a probable recession in Europe due to rising inflation and the fallout from the war in Ukraine. China, the world’s second largest economy, is also forecast to slow down this year to almost half of last year’s growth.
  • Globally, markets and sentiment saw a recovery during March, but both are at risk in the coming weeks as company CEOs provide forward guidance as to the impact of the uncertain environment on their earnings prospects for the year.
  • Market risk levels, which drove most of the recent recovery in investor sentiment, are highly uncertain and subject to the progression of both inflation and the war in Ukraine. Any negative developments this week on either front could send risk levels rising again and stop the recovery in sentiment, which continues to be fragile.
  • The supply and demand balance for risk has improved to a level where a sharp overreaction to negative news is now unlikely. However, confirmation that the earnings outlook needs to be revised down as a result of rising inflation will cause sentiment and markets to head back down in the coming weeks.

US investor sentiment:

US investor sentiment (green line) continued to recover, ending the week slightly negative but no longer bearish. Sentiment has been rising for four consecutive weeks on the back of the US economy’s relative safe-haven status from the war in Ukraine given its low reliance on Russian commodities, and on falling volatility levels. This recovery was capped later in the week by the rising risk of recession resulting from the Fed’s hawkish response to surging inflation. Economists surveyed by The Wall Street Journal this month on average put the probability of the economy being in recession sometime in the next 12 months at 28%, up from 18% in January and just 13% a year ago. The Q1 2022 earnings reporting season kicks off this week, and analysts expect earnings for S&P 500 companies to have grown by an annual 4.6% during the period, according to FactSet. Forward guidance and companies’ response to rising inflation will have a major impact on sentiment.

Risk aversion (red line) and risk tolerance (green line) continued to converge towards equilibrium last week. The gap between risk tolerance and risk aversion has not been this small since November last year. This means that the number of potential sellers in the market does not outnumber the number of potential buyers by enough to cause a large downside price movement in the event of negative news. One of the main drivers of this improvement in the supply and demand for risk has been declining market risk, which remains very much subject to the situation in Ukraine and on the inflation front. The start of the earnings reporting season will keep investors focused on company specific news for the next few weeks, and baring any dramatic developments in Ukraine, stock-level pairwise correlation should continue to decline and provide further downside momentum to predicted market risk.

European investor sentiment:

European investors’ sentiment (green line) staged a small recovery last week on the back of declining market risk, but remained bearish. Sector allocations point to a further deterioration in investors’ outlook for both the market and the economy (red dotted line). The war in Ukraine continues to affect sentiment in Europe more than it does in the US. Given the deteriorating sentiment, any uptick in market risk will trigger an overreaction to the downside for markets as investors rush to de-risk portfolios.

Risk-aversion (red line) retreated slightly last week, while risk tolerance (green line) continued to rise. Most of the improvement in the supply-and-demand balance for risk was driven by declining market risk. The issue with market risk being the driver of sentiment is that this metric can easily reverse course and become a negative for investors, especially in thin volume ahead of the Easter holiday across major markets in Europe. As the war in Ukraine remains volatile and unpredictable, it will continue to affect sentiment in Europe, preventing it from returning to a more positive stance. This will weigh on markets, which will find it hard to even hold on to recent gains in the near term.

Global developed markets investors sentiment:

Sentiment among global developed-markets investors (green line) ended the week still bearish, despite recovering from its mid-March lows. A slight improvement in global market risk helped sentiment rise in the past two weeks, but investors continue to implement mostly risk-averse strategies via their sector allocation (red dotted line). As investors continue to assess the impact of prolonged inflationary pressures on the global economy, they are likely to remain risk-averse in the near term. Most economist now forecast a return to central banks’ target levels of inflation in Q4 2024, a year later than they had forecast three months ago. Further downgrades to their forecasts will see both markets and sentiment head lower in the short term.

Risk tolerance (green line) seems unable to rise given the level of uncertainty in the market. Risk aversion (red line), meanwhile, declined only marginally as lower market risk levels were countered by higher fears about the global economy’s ability to avoid recession in coming quarters. The imbalance in the supply and demand for risk is still very negative and indicative of a strong lack of risk appetite. At these levels, any negative news event can still cause an overreaction to the downside and send markets back to test their February lows. Conversely, sentiment seems still too weak to allow for positive news to send markets up past their January highs.

Asia ex-Japan markets investor sentiment:

Sentiment among Asia ex-Japan investors (green line) rose for the third consecutive week, ending just shy of neutral. As in other markets, lower market risk levels drove most of the improvement as sector allocation indicate that the implementation of risk-averse strategies persists among investors (red dotted line). Economically, the region depends on global growth, which is threatened by rising inflationary pressures, a more hawkish monetary policy response by major central banks, and ongoing supply-chain disruptions from city-wide COVID-19 lockdowns in China. A more sustainable and credible recovery in sentiment is still a long way off and will require answers to how the US-China relationship will evolve.

Risk tolerance (green line) continued to rise last week, while risk aversion (red line) seesawed but ended the week lower. Net risk appetite has improved but is still negative, and risk aversion levels remain on the uptrend they started back in early November 2021. Too many potential factors affecting the region still weigh on sentiment and are likely to keep risk aversion levels above those of risk tolerance in the near term.

Global emerging markets investor sentiment:

Sentiment among global emerging-markets investors (green line) rose sharply for the third consecutive week, ending neutral for the first time since January. Unlike in other markets, the recovery in sentiment was accompanied by the implementation of more risk-tolerant sector allocations by investors (red dotted line). As in other markets, the recovery in both markets and sentiment was supported by declining levels of market risk from their February highs, but any reversal in volatility levels will have strong negative impacts on a still fragile and uncertain outlook.

The gap between risk aversion (red line) and risk tolerance (green line) all but closed last week, returning the supply and demand for risk to equilibrium. Contrary to most other markets, the rise in net risk appetite was driven mostly by a surge in risk-tolerance levels in the past three weeks, rather than a decline in the level of risk aversion. This could indicate that investors in global emerging markets are more positive than elsewhere and will be less prone to overreaction in the event of negative developments on the global macro data front in the near term.