Potential triggers for sentiment this week1 :
- US: FOMC meeting minutes, retail sales, producer inflation and housing data.
- Europe: UK unemployment data and the situation in Ukraine.
- APAC: China and Japan inflation data, Japan Q4 2021 GDP.
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 ended the week bearish in all markets we track, with investors in emerging markets and China joining all others after weeks of being slightly less negative. The end of the quarterly earnings season means a return to macro and geopolitical news as main drivers of investor sentiment. Both were negative influences last week, with higher-than expected US inflation numbers and repeated warnings by the Biden administration that war in Ukraine could start “any day”.
- Investing is forecasting — you can’t get away from that fact. But for forecasting to have any credibility, even when it is cautious, hedged, and quadruple-qualified, it requires a background of tolerable ambiguity. Instead, what we have now, is an environment of intolerable uncertainty, giving forecasts of returns the same level of credibility as medical advice from the Internet.
- When confidence intervals around returns forecasts are so wide as to render them useless, risk, in the form of potential losses, is what dominates decision-making. And currently, risk is too high for most investors’ comfort. This helps explain why portfolios constructed to reflect a risk-averse strategy continue to outperform year-to-date both the broad market and portfolios reflecting a risk-tolerant strategy (more details here).
- A bearish sentiment means that even mild negative news will trigger an overreaction. It can lead to a negative loop, where more and more investors overreact to a continuous flow of negative news. This classical circularity eventually exhausts itself, but it will take a steady stream of positive news to get the pendulum to swing in the other direction.
US investor sentiment:
US investor sentiment (green line) declined further last week on the back of heightened market volatility, higher-than expected CPI data, and a rather alarmist rhetoric on the situation in Ukraine by the Biden administration. Sentiment has been bearish for almost two consecutive months now (it turned bearish on December 20, 2021), and is on track to exceed the bearish stretch around the COVID-19 crash of March 2020 (February 21 to April 17, 2020). Given the absence of either additional monetary or fiscal stimulus in the short term, sentiment is unlikely to recover as fast as it did in 2020 and should remain very negative until inflationary pressures show clear signs of declining. The Federal Reserve has not yet started fighting inflation with higher rates, and is still conducting asset purchases. One of the key drivers of negative sentiment is the nagging suspicion that the Fed may have left it till too late to act.
Risk aversion (red line) remained at its highest level since March 2021. Risk tolerance (green line) meanwhile remains at lows not seen in the last decade. This puts net risk appetite at its most negative level in more than ten years. A negative news at this level would trigger a large downside overreaction as potential sellers outnumber potential buyers more than two-to-one. This is an environment that will continue to favor risk-averse assets over risk-tolerant ones.
European investor sentiment:
European investor sentiment (green line) remained bearish last week but did not worsen, and continues to hold on to the small gains made in late January. Strategy implementation has reverted to a risk-averse sector allocation (red dotted line), powered in part by the reallocation into banks (the STOXX Europe 600 Banks Index rose almost 4% in euros last week) after the ECB’s inflation pivot and the BoE’s second consecutive rate hike. Sentiment in Europe could recover faster than in the US given the weight of the financial sector in its indices. A trigger for the recovery could be a de-escalation of tension in Ukraine over the next few days, which would coincide with the reopening of major economies in Europe as the pandemic situation improves.
Risk aversion (red line) and risk tolerance (green line) continue to point towards a negative net risk appetite with the situation stabilizing around current levels. The imbalance between the potential supply and demand for risk remains high but does not appear to be deteriorating further — even in the face of what is currently a negative narrative on the Ukraine front. This could be a sign that most of the negative news has been priced in at current levels and that investors have adopted a wait-and-see attitude for now.
Global developed markets investors sentiment:
Sentiment among global developed-markets investors (green line) continues to seesaw within the bearish zone, neither recovering nor deteriorating further. Investors have been bearish since late October 2021 and there may be a kind of bearish fatigue that is preventing sentiment from dipping lower despite large negative market moves and higher volatility. Still, at these levels, sentiment remains a drag on markets, preventing any prolonged rally until it recovers. Much will depend on the global inflationary outlook, and in the short term, the situation in Ukraine. The latter is unlikely to have a long-lasting impact and may simply provide an outlet for the remaining bearish sentiment to be released, paving the way for a recovery in sentiment post-shock.
Risk tolerance (green line) remained near its lows last week while risk aversion (red line) declined slightly. Risk appetite remains very negative with potential sellers outnumbering potential buyers but the continued decline in risk aversion since the highs at the start of the year points to a decreasing likelihood of a sharp downside overreaction like the one experienced in late January. The imbalance is still in favor of risk aversion but there are signs that investors are learning to live with it.
Asia ex-Japan markets investor sentiment:
Investor sentiment (green line) in Asia ex-Japan continued to recover last week but ended still bearish. Markets here remain under pressure from the three headwinds: the prospect for higher US interest rates as early as March, ongoing economically restrictive pandemic responses, and the state of the US-China relationship. Most of this has been priced into current market valuations, as regional indices have underperformed for two consecutive years now, but the uncertainty shadow these issues still cast needs to be removed before a recovering sentiment can power markets into a sustainable rally (as we saw last November).
Risk tolerance (green line) continued its gradual recovery last week while risk aversion (red line) remained flat. As in other regions, the decline in risk aversion these past few weeks is larger than the gain in risk tolerance, indicating perhaps a certain degree of bearish fatigue among investors. Bearishness is a sentiment that eventually wears itself out, even without a major market correction, but something must come along to lift risk tolerance and create that sustainable positive risk appetite. Investors do not take on extra risk just because they are tired of being scared.
Global emerging markets investor sentiment:
Sentiment among global emerging-markets investors (green line) declined sharply last week with the return to market of Chinese investors. Sentiment had been on a recovery path since mid-January but failure to recover positive levels earlier this month seems to have led to a disappointment phase with sentiment dipping back into bearish levels. The pandemic narrative is still a negative one among emerging markets, especially on the vaccination front, and investors remain worried about supply chain disruptions in the developing world. Valuations at current levels already reflect these concerns, and so any improvements in the outlook for these economies translates into a rapid recovery in both sentiment and market prices. Of all the regions we track, global emerging markets (and China) have seen the fastest rebound in sentiment, even if it was unsustainable.
Risk aversion (red line) continued to rise sharply last week, while risk tolerance (green line) gave up some of the gains it made in late January. The newly opened gap between the two remains small, however, despite being indicative of a negative risk appetite in the short term. As with other markets discussed above, risk appetite is driven by directional changes in risk aversion levels rather than risk-tolerance ones. In short, investors are quick to find reasons not to be scared anymore, but are much slower in finding reasons to become more bullish. We suspect this is a situation that will continue for the rest of the quarter, if not the first half of 2022.