ROOF Highlights — January 17, 2022

Qontigo ROOF™ Score Highlights: Week of January 17, 2022

Notes to our readers. As we start 2022, we have made one small adjustment to our Sector ROOF Score methodology. The cap-weighted sector portfolios will now be constructed using the same free-float adjustment factor used across all our indices. This has had some minor, non-directional effects on our history, but we believe this change will better capture investor behavior by focusing solely on the assets they can use to implement their strategies.

Potential triggers for sentiment this week1 :

  • US: earnings season continues with Bank of America, Goldman Sachs, Morgan Stanley, P&G and Netflix reporting results.
  • Europe: ECB meeting minutes, UK inflation, Eurozone consumer confidence data.
  • APAC: Bank of Japan and Bank of China interest rate decisions, and China Q4 GDP, retail sales and industrial production data.

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 remained very negative last week in all markets we track except Japan and China, which staged minor recoveries on domestic stimulus talks. Weaker-than-expected macro data out of the US (retail sales and industrial production), a worsening inflation picture globally, rising tensions in Ukraine, a slowing China, and more hawkish speeches by Fed members, all weighed on sentiment.
  • Investors have been fretting about inflation for a year now, nervously anticipating the level at which it will drive markets out of the utopia they have been in for the past three years, and into the dystopia of slow growth and rising interest rates. The prevailing bias seems to be that after three consecutive years of above-trend positive market returns, surely there cannot be a fourth, can it?
  • Inflationary pressures are the hottest they have been for several decades, to be sure, but the heat has so far been all in investors’ armpits. Corporate earnings have been strong, profit margins unharmed, and CEOs have repeatedly said they were able to pass higher costs onto consumers who seemed willing and able to pay them. But that was last year’s story.
  • The current weak sentiment level means investors need reassurance from CEOs over the next three weeks that nothing has changed vis-à-vis their ability to deal with supply-chain bottlenecks and higher consumer demand – even if all the evidence in front of them at the supermarket says otherwise.
  • The ongoing surge in Omicron infections and worsening geopolitics will be distracting investors in the next few weeks as these issues jostle for front-page space with individual company results for Q4 2021 and guidance for 2022. With sentiment this low, negative earnings surprise or guidance will be swiftly punished by an increasingly nervous and bearish investor base.
  • Conversely, a convincingly bullish earnings outlook from company executives, and the promise of further Omicron-related fiscal stimulus by governments, could convince some investors to dive back in, and that those prophecies of stagflation and a sharp market correction may both turn out to be swindles.

US investor sentiment:

US investor sentiment (green line) continued to decline last week, remaining bearish for the fourth week in a row, and pulling markets down from their recent record-breaking highs. The earnings reporting season for Q4 2021 has started and expectations are high (+22% YoY according to Factset) that the last quarter was a good one for companies. The data released so far this year for December 2021 (i.e., retail sales and job creation), however, paints a different picture of how the economy ended the year. Once again, forward guidance will have more of an impact on investor sentiment than past performance, and CEOs will need to address how inflation and the lack of monetary and fiscal stimulus will affect their businesses in 2022. As of last week, investors continued to favor the implementation of defensive strategies by allocating more of their assets to sectors that perform better in a risk-off market than in a risk-on one (red dotted line).

Risk aversion (red line) and risk tolerance (green line) remained flat last week, keeping in place the large net negative supply-and-demand imbalance in the market. With sentiment this weak, and volatility already at an above-average level, any geopolitical risk event (e.g., invasion of Ukraine by Russia), will cause a volatility spike, resulting in an overreaction on the downside by investors needing to de-risk their portfolios by dumping assets in a market with few(er) risk-tolerant investors willing to buy them. On the positive side, the negative impact of geopolitical events is usually short-term. A sharp market correction caused by an overreaction to the risk event, could provide risk-tolerant investors with a bargain-hunting opportunity.

European investor sentiment:

European investor sentiment (green line) declined sharply last week, ending at a new 52-week low. This further deterioration in sentiment was driven by higher market volatility, reflecting increased geopolitical tensions (Ukraine) as well as a darkening macroeconomic picture. Rising inflation is seen as weighing on consumer demand, while the ongoing Omicron wave is seen as continuing to disrupt the global supply chain. Domestic shenanigans by leaders in France and the UK are adding to the ongoing worries about dangerously escalating geopolitical tensions between NATO and Russia. A positive resolution on either the Omicron or Ukraine front seem unlikely before the end of the month. If sentiment remains bearish, markets will continue to be susceptible to sharp pullback on an over-reaction to a risk event.

Risk aversion (red line) shot even higher last week, while risk tolerance (green line) continued to decline to new lows. At these levels, risk appetite is very negative, and any risk event will trigger a sharp market correction as risk-averse investors rush to off-load risky assets in a market with a very low demand for risk. European investors have plenty of reasons to be bearish, but the ECB’s ongoing stimulus program has thus far kept them from selling their risk assets. Since September, they have implemented strategies favoring sectors that will protect their downside in the event of a sharp market rout (red doted line).

Global developed markets investors sentiment:

Sentiment among global developed-markets investors (green line) remained bearish last week, neither recovering nor worsening. Sentiment has been bearish since late October, preventing markets from rising above their early November highs, and causing two corrections: one in December and one so far in January. This negative mood is likely to continue to weigh on markets, keeping rallies on a short leash and driving volatility higher in the short-term. At these levels, investors are looking for an excuse to sell, and a reason to hold. Not an excuse to buy. An excuse to sell can come either in the form of a risk event, or, more simply, of a bid at a higher price.

Risk tolerance (green line) and risk aversion (red line) remain far apart from each other, describing a very negative risk appetite. At these levels of risk aversion, the bias is clearly to the downside for markets in the short-term. The trigger for an overreaction from investors could come from either renewed lockdown measures due to the Omicron situation, or an escalation of tensions between NATO and Russia over Ukraine. Both risk factors are unlikely to disappear in the next two weeks, which should keep investors on edge for the rest of the month and keep markets in check.

Asia ex-Japan markets investor sentiment:

Sentiment (green line) among Asia ex-Japan investors has been declining since late November, and became bearish late December. Year-to-date, it has continued to slope downward, becoming increasingly bearish each week. The region was a strong underperformer in 2021, failing to capitalize on a surge in sentiment between September and November. Regional investor sentiment points to expectations of continued underperformance in the near term. The risk factors weighing the most on sentiment are the prospect of higher US interest rates, and the deteriorating relations between the US and China. Neither seem likely to turn into positive factors for the markets here any time soon. The US-China relationship is even likely to become a pond in the upcoming US mid-term election, which should result in an increase in tension during the rest of the year.

Risk tolerance (green line) flattened near 52-week lows last week, while risk aversion (red line) surged. Risk aversion is now clearly dominant and posing a near-term downside risk for markets. A strongly negative risk appetite means that investors are much more likely to sell on bad news than they are to buy on good news. Given this bias, investors would do well to keep protecting the downside in the near term.

Global emerging markets investor sentiment:

Sentiment among global emerging-markets investors (green line) became increasingly bearish last week, continuing a trend of declining sentiment that started in late November 2021. Emerging markets saw negative cumulative returns for all of 2021, but even at these low valuations, the prospect of higher US interest rates in 2022 creates even more headwinds for them in 2022. The economic dynamics between emerging and developed markets is epitomized by the US-China relationship, which has been at a low since 2018 and shows no signs of improving. Unprecedented levels of QE in developed markets kept investors at home (developed markets) in 2021, but even with a more hawkish Fed, emerging markets will need to give investors a reason to take on the additional risk in 2022.

The negative gap between risk aversion (red line) and risk tolerance (green line) widened last week, reflecting a weakening risk appetite among emerging-markets investors. With rising commodity prices and the prospect for slower growth in developed economies in 2022, it is hard for investors to feel bullish in the near term. It will take a rapid warming of the US-China relationship for sentiment to turn around — something that seems unlikely ahead of the US mid-term election.