ROOF Highlights — January 3, 2022

Qontigo ROOF™ Score Highlights: Week of January 3, 2022

Notes to our readers. Happy new year from all of us at Qontigo. 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 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: FOMC minutes, jobs report, PMI surveys, factory orders.
  • Europe: PMI surveys, inflation rates for the Eurozone.
  • APAC: Japan consumer confidence.

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 2021 on a very bearish note across all markets we track. Inflation continues to be the main worry curtailing risk appetite. Although the impact of the Omicron coronavirus variant on the global economy seems to be less than expected, this does not alleviate investors’ concerns that central banks may be falling behind the curve on inflation and will be forced to play catch-up later, with potentially very negative consequences for markets.
  • The recent rise in market volatility may not be helping sentiment but it certainly isn’t the main driver of the rise in investors’ risk aversion either. Excluding market risk concerns, sector allocation decisions across all markets we track indicate the implementation of more risk-averse strategies as we head into the new year (red dotted lines in the charts below).
  • These bearish levels in investor sentiment point to an increase in uncertainty and a widening of confidence intervals around forecasts for 2022. Forecasting in 2020 was simple and driven almost exclusively by the massive QE programs. An opaque inflation picture in 2021 raised the uncertainty around those forecasts. Going into 2022, resurging geopolitical hotspots are adding to the murkiness of outlooks. The increase in uncertainty is driving investors, whose confidence-adjusted forecasts are no longer positive enough for the current market risk levels, to implement more risk-averse strategies in the short-term.
  • 2020 was the year of the bulls. 2021 the year of the skeptics. Current sentiment seems to bet on 2022 being the year of the bears. Sector and style factor allocations in 2021, reflected the implementation of cautiously optimistic strategies. Investors seem to head into 2022 with a strong sense of foreboding and are implementing strategies that prepares them for the worst.
  • In short, investors are opting to focus on preventing a lot of money from becoming a little, rather than focusing on trying to turn a little money into a lot.

US investor sentiment:

US investor sentiment (green line) turned bearish in the final days of 2021, despite markets hitting fresh historical highs in holiday-light volume. This negative sentiment is likely to cap further advance by markets in the short term and should continue to reward risk-off strategies more than risk-on ones. Sector allocations (red dotted line) point to a continued implementation of risk-off strategies betting on the more risk-averse sectors. This should continue to favor positive style exposures like value, low volatility, size and profitability, as well as sectors like consumer staples, energy, financials, and utilities – all characteristic of risk-off portfolios.

Risk aversion (red line) reached a new year-high and risk tolerance (green line) a new year-low last week, even as markets hit fresh records. This reflects the continued popularity of strategies that took on less risk than the market but remained hopeful that above-average growth was still possible in 2021. Going forward, the potential supply of risk asset (red line) is now much higher than the potential demand (green line), and at the same time, valuations for risk-averse sectors and styles reflect a year-long popularity and may be too rich to attract further rotation volumes without a sharp discount. Given the large net negative risk appetite in the market today, the next negative news event could trigger a rapid market correction.

European investor sentiment:

European investor sentiment (green line) took a decidedly negative turn during the holidays, ending the year in bearish territory. This negative sentiment should continue to cap any market attempts at new highs and ensure each one is followed by a sharp correction, as has been the case during Q4 2021. Market valuations are now far ahead of sentiment and heading in the opposite direction – a state of affairs that isn’t sustainable. Uncertainty is now higher than it was during all of 2021, which hinders a sharp improvement in sentiment in the short term. Much more likely is a market correction from current levels as investors return from the New Year holidays and resume de-risking their portfolios to reflect the lack of confidence in their 2022 forecasts.

Risk aversion (red line) rose sharply in the final days of 2021, while risk tolerance (green line) remained near its lows for the year. This reflects a situation where, with very little risk tolerance to begin with, investors are finding that rising uncertainty is only adding to their need to de-risk their portfolios and focus on protecting the downside rather than gearing up to take advantage of any potential upside.

Global developed markets investors sentiment:

Sentiment among global developed-markets investors (green line) continued its recent decline, ending last week deep in bearish territory. In a global portfolio context, multiple domestic macro issues like inflation and monetary policy accrue across markets to chip away at investors’ confidence in their forecasts. Add an increasingly hostile geopolitical environment and a couple of highly partisan elections in 2022 (France, US, China), and uncertainty could easily get worse. This state of mild neurosis is likely to continue in the short term (at least until the next earnings season) and cap any market rally. More likely is that any rally will be seen as a good opportunity to de-risk portfolios at an attractive price.

Risk tolerance (green line) remains near its low for the year, while risk aversion (red line) received a boost from continued macro and geopolitical worries. At these levels, the imbalance in supply and demand for risk is clearly on the supply side and any negative news or risk event (e.g., extreme weather, or any country’s attempt at annexing a large swath of another country’s eastern provinces without permission), could trigger a sharp correction.

Asia ex-Japan markets investor sentiment:

Sentiment (green line) among Asia ex-Japan investors weakened further during the holiday season, ending 2021 in bearish territory. Investors have become increasingly bearish for 18 consecutive days, making any market rally attempt punishable by a deeper retraction immediately after. Both the deteriorating US-China relationship as well as the imminent change in US monetary policy direction is weighing on sentiment, especially given the backdrop of potential credit defaults among some of the large Chinese real estate companies. In the short term, rising uncertainty will continue to drive further risk aversion, and markets will continue to punish investors who show more risk-tolerance or confidence than they have the right to have.

Risk tolerance (green line) seems to have flatlined near its lows recently, while risk aversion (red line) continues to rise on the back of increasing uncertainty caused by the accumulation of macroeconomic, health, and geopolitical issues. Of these concerns, health worries with the Omicron variant seems to be the one with the highest potential to be a short-term influence, while the other two will linger on for some time and continue to affect sentiment. Given their binary nature and blunt impact on markets, investors may choose to remain on the defensive until clarity returns.

Global emerging markets investor sentiment:

Sentiment among global emerging-markets investors (green line) ended the year bearish after declining since the end of November. Fund flows failed to materialize during all of 2021 and, given the change in US monetary, investors will need serious reasons to venture outside developed markets, which have been very good to them for three consecutive years now. Valuations are attractive but without global growth (or global peace), emerging economies are unlikely to become more attractive than developed ones in the short term.

The negative gap between risk aversion (red line) and risk tolerance (green line) widened further in the last few trading days of 2021, pushing the supply and demand balance for risk sharply in favor of the former. The last time risk appetite was so low was in August 2021, which was the start of a month-long market correction. At these levels, the imbalance is large enough to cause a sharp market correction if triggered by a negative news event. With more downside risk than upside potential, investors may well continue to favor risk-averse strategies over risk-tolerant ones.