Potential triggers for sentiment this week1 :
- US: Services and Manufacturing PMI data.
- Europe: Services and Manufacturing PMI data for France, Germany, the UK and the Eurozone.
- APAC: Services and Manufacturing PMI data for Japan.
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:
- For the second time this month, investor sentiment across all markets we track ended the week bearish. This negative state of mind is not new: investors in developed markets became bearish in late December 2021, and have only recently been joined by investors in Japan, China, and global emerging markets. Sentiment first became bearish due to inflation concerns, and it has remained bearish due to fear that President Putin might unleash the dogs of war in Ukraine. What we have now is fear on fear. The former rational, the latter, emotional.
- There are two kinds of volatility. Good volatility — caused by changing fundamentals forcing investors to update their forecasts and rebalance their portfolios accordingly (e.g., the Fed’s inflation pivot). And bad volatility — caused by high uncertainty around risk events with unpredictable binary outcomes (e.g., Russia/Ukraine conflict). Sentiment has been weakened by good volatility since Q4 2021, and battered by the additional bad volatility from the Ukraine situation since the start of February.
- High uncertainty turns every ordinary decision into a series of trick questions, with every incorrect answer instantly punishable by widening losses. Bad volatility turns an ordinary market into a hurricane, ripping through investment theses, leaving only splinters and shards of the original forecast behind. In the face of bad volatility, investors will naturally de-risk their portfolios, as instinctively as they would open their umbrellas in the rain. Decision-making comes to a standstill as returns forecasts are trip-wired by rising uncertainty.
- On the positive side, bad volatility situations can usually be resolved quickly, and there are signs that investors have already reached bearish fatigue. Sector allocations shows that they have stopped loading on risk-averse sectors and even engaged in some bargain-hunting among risk-tolerant ones in preparation for a possible relief rally were the situation in Ukraine to have the happy diplomatic ending everyone is hoping for (see red dotted line in charts below). At this point, ironically, even the start of hostilities would provide investors with an answer to a question at the root of the recent bad volatility. Once they know what we’re dealing with in Ukraine, and how the world intends to respond, they’ll be able to forecast once again and regain their footing in terms of allocations.
US investor sentiment:
US investor sentiment (green line) remained bearish and directionless last week, held in position by elevated levels of market volatility. We note that sector allocations reached peak bearishness during the last week of January, and investors have been gradually rotating into oversold and more risk-tolerant sectors since then (red dotted line), in a sign that some expect the year-to-date market correction to have run its course. As of now, continued high volatility levels mean investors need to be defensive, but sector allocations show that they want to be more risk-tolerant and that the balance between bulls and bears may be about to change. This rotation will accelerate if volatility declines, which could happen rapidly if tensions in Ukraine deescalate.
Risk aversion (red line) and risk tolerance (green line) remain far apart from each other with the former dominating the latter two-to-one and keeping risk appetite near its 52-week lows. The imbalance between bulls and bears in the market is now so large that it could hardly increase from these levels, and the more likely next move is for it to narrow. Risk appetite tends to mean-revert, and the current extreme level seems unsustainable from a historical perspective.
European investor sentiment:
European investor sentiment (green line) dipped slightly last week, ending its recovery from the lows reached in late January. The projected differential in monetary policies between the Federal Reserve and the ECB had originally caused European investors to start rotating out of risk-averse sectors and into risk-tolerant ones in late December 2021. This rotation continued through January this year with the projected reopening of major economies across Europe post the Omicron wave, but the ECB’s own inflation pivot earlier this month forced investors to unwind those positions and return to a risk-averse strategy implementation in February (red dotted line). It seems that due to both monetary policy changes and higher volatility levels from uncertainty over the situation in Ukraine, European investors both want to and need to stay defensive for the time being.
Risk aversion (red line) levels remained elevated last week but did not return to previous highs. In contrast, risk tolerance (green line) levels dipped to fresh lows, indicating a total lack of risk appetite from investors at this point. If markets are to recover from their recent selloff, it will have to be on the back of sentiment becoming less bearish rather than more bullish. The will to implement a more risk-tolerant strategy does not seem to be there currently.
Global developed markets investors sentiment:
Sentiment among global developed-markets investors (green line) rose sharply last week but remained bearish. The recovery follows a recent rotation into more risk-tolerant sectors that began in late January (red dotted line). To be clear, both strategy implementation and sentiment remain defensive but not as bearish as they were in the previous month. Global markets have sustained a healthy correction year-to-date, reflective of this bearish sentiment, and valuations may have reached a level at which they are once again attractive to investors with a longer investment horizon. With global (risk) diversification on their side, central banks focused on the inflation headwinds, and the rest of the world trying to hold back Russia in Ukraine, sentiment could rapidly improve from here by leveraging its current recovery momentum.
Risk tolerance (green line) rose last week while risk aversion (red line) continued to decline. Weakness in the latter has led the recent recovery in sentiment, and may have reached a level at which risk tolerance can now take over as the driving force behind rising risk appetite going forward. Still, investors will need some reassurance that the situation in Ukraine will not worsen before sentiment can turn bullish, or even just neutral, from here. Risk aversion is saying that things are not as bad as investors thought, but risk tolerance will need a little more encouragement to convince them that it is now safe to implement risk-on strategies.
Asia ex-Japan markets investor sentiment:
Investor sentiment (green line) in Asia ex-Japan remained bearish last week. The rotation from a risk-averse to a risk-tolerant sector allocation (red dotted line) that took place in January went into reverse last week, capping the recent market gains. Valuations in Asia ex-Japan remain low after two consecutive years of underperformance, but the region is dependent on positive fund flows and low interest rates, both of which have turned into headwinds with the recent inflation pivot by major central banks. And so, most of the bearish sentiment in Asia ex-Japan comes from the good kind of volatility, which unfortunately has negative consequences for both the region’s lenders and borrowers that dominate regional benchmarks. Developed markets may recover once the bad volatility drops but Asia ex-Japan markets will require a fall in both bad and good volatility before they stage a sustainable recovery.
Risk tolerance (green line) continues its timid recovery from its 52-week low reached in January, but risk aversion (red line) is rising at a faster pace, signaling that the negative risk appetite is driven by fear more than by a lack of greed. The negative fundamentals facing the region do not have a short-term solution and it will take a prolonged decline in global inflationary pressures to reverse them before risk tolerance can once again become an influencer. Until then, risk aversion remains in the driver’s seat.
Global emerging markets investor sentiment:
Sentiment among global emerging-markets investors (green line) bounced off its recent lows last week but remains bearish. Like its global developed peer, global emerging markets benefit from international diversification but remain subject to fund flows from developed markets to sustain a recovery after two consecutive years of underperformance. The issue for investors is not one of volatility, as emerging markets currently enjoy the same or lower volatility as their developed peers, but rather one of forecasted future returns. Chinese companies dominate the index and the fundamentals for these constituents point to a slowing economy, rising credit risk, and a delayed reopening due to the country’s zero COVID-19 strategy. Domestic political risk and higher US interest rates is also hampering forecasts for Latin American companies, leaving only the Middle East as a bright spot due to rising oil prices. Sector allocation (red dotted line) points to a rather neutral strategy implementation of late, but it has now failed twice to show a preference for the implementation of a risk-on strategy, signifying that investors will require more positives on the fundamental front to turn bullish.
Risk aversion (red line) halted its recent rise last week, while risk tolerance (green line) remained flat. As in other markets, investors’ risk appetite is driven more by changing risk-aversion levels than risk-tolerant ones. As noted above, risk aversion levels are not subject to the bad volatility from heightening tensions in Ukraine but more from investors’ changing forecast on how soon, how fast and how high US interest rates will rise during 2022. Given that these expectations are still on an upward trend, it may be a while more until risk appetite in emerging markets is driven by risk tolerance rather than risk aversion.