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ROOF Highlights — July 19, 2021

Qontigo ROOF™ Score Highlights: Week of July 19, 2021

Potential triggers for sentiment this week1 :

  • US Q2 earnings season continues with IBM, Netflix, Intel, J&J, and Twitter reporting
  • Preliminary PMI surveys for the US, UK, and Eurozone
  • ECB update on monetary policy stance
  • UK retail sales and Eurozone consumer confidence

Summary of changes in investor sentiment from the previous week:

  • Investor sentiment declined from recent highs in all major regions last week, with investors in Developed Europe curbing the recent surge in enthusiasm and rejoining others in the ambivalence of neutral zone.
  • If not for the continued decline in predicted risk (and associated expected losses), sentiment in the major markets would not have risen as much recently, and would even be lower now than it seems, especially in Developed Europe (see red dotted line in regional charts below).
  • The recent drop in sentiment indicates that investors feel markets have done more than expected with less than they should need to reach those valuation levels, and that perhaps ultra-easy monetary policies are distorting the true risk picture.
  • Investors seem conflicted between the appeal of a QE-fueled market rally and the ephemeral strength of the economic recovery which remains only a viral variant away from weakening again. It is like asking them to choose between The Beatles or The Rolling Stones.
  • This state of confusion from mixing unprecedented quantitative easing with a weakened economy, amidst geopolitical uncertainty, is not an ailment for which investors currently have a remedy. As a result, and having quite a lot of performance to lose at these levels, risk aversion is growing surreptitiously around markets.

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

US investor sentiment:

Sentiment among US investors continued its recent decline to end last week in the middle of the neutral zone. At this level, investors are uncertain about the near future, pointing to a directionless market in the short-term. We note that the gap between the sector ROOF ratio (green line) and the sentiment level excluding the two risk metrics from the methodology (red dotted line) is closing fast and both are trending down lately. This indicates that declining volatility is no longer a major influence and that the recent weakness in sentiment is driven more by an ongoing rotation towards portfolios with a more balanced exposure to risk-tolerant and risk-averse sectors.

Risk aversion (red line) and risk tolerance (green line) continued to head towards equilibrium last week. Given this lack of imbalance between the supply and demand for risk in the market, buyers and sellers will have no problems finding a counterparty for their needs without having to offer large price premiums or discounts, keeping markets in a tight range. Net risk appetite retains a slight positive edge given the limited downside risk from ongoing central banks’ asset purchasing programs capping the downside. Given this very public stop-loss, the recent rise in risk aversion should not be interpreted as a rising bearish sentiment, just rising skepticism: “Another year of 30%-plus performance is possible, but unlikely”.

European investor sentiment:

European investor sentiment retraced its bullish steps from the previous week, weakening to end last week on the edge of the neutral zone. We note that the declining volatility of the last few months has not had as big an impact on sentiment in any other markets than in developed Europe. Removing the impact of the declining volatility on sentiment, the ex-risk ROOF Ratio (dotted red line), peaked in mid-June and has been weakening since, ending last week near the border between the neutral and the bearish zones (at -0.34). The divergence between the two ratios indicates that investors have been (reluctantly?) increasing their exposure to market risk but have opted to load on the more defensive segments of the market to achieve this (i.e., career risk may be making them jump in to remain compliant with their risk mandates, but they are doing so with an eye to protect their portfolios from downside risk).

The imbalance between risk aversion (red line) and risk tolerance (green line) stopped just short of a bullish signal last week before reverting to a more balanced position. Risk tolerance (a.k.a., the demand for risk) is being supported by the decline in predicted volatility which limits both the probability and the size of potential tail loss, but as noted in previous reports, with volatility well below its long-term median, there is probably nowhere else for them to go from here but back up. The recent rise in new infections from the Delta variant of the COVID-19 virus may have made investors feel like a plump trout, and that underneath this low volatility regime lies a barbed hook.

Global developed markets investors sentiment:

Global investor sentiment continued to decline last week ending at the bottom of the neutral zone. At these levels, investors are not bearish yet, but can be said to be no longer hopeful (i.e., “if it looks good, don’t count on it, and if it looks bad, it’s probably worse than we thought”). Here too the ex-Risk ROOF Ratio is below the standard Sector ROOF Ratio and has already crossed into the bearish zone (-0.64). This decline in sentiment, despite an ongoing low-risk environment will make it hard for markets to climb higher in the near-term.

Risk tolerance (green line) has now dropped below risk aversion (red line) levels, translating to a slight negative (bearish) supply-and-demand balance for risk (i.e., there are now more risk-averse investors than risk-tolerant ones in the market, but not overly so). In the near-term, we expect net risk appetite to remain in the neural zone unless a risk event causes volatility to rise, sending both risk metrics in our methodology to the risk aversion side. As in other markets, however, with volatility being low by historical standards, the probability of continued support from this metric seems unlikely and we may be seeing the calm before the storm in terms of investor sentiment.

Asia ex-Japan investor sentiment:

Asia ex-Japan sentiment continued to retreat last week, weighing on markets. Sentiment ended the week back inside the neutral zone from its previous month-long stint in the bullish zone. Rising volatility due to a resurgence of geopolitical risk (i.e., US-China tension) dragged sentiment lower and helped close the gap between sentiment with the two risk metrics (green line) and sentiment without (red dotted line). The fate of the region remains tied to the strength of the global economic recovery, and despite a few localized COVID-19 Delta variant flareups, investors remain mostly hopeful economic growth will eventually overcome restrictions from the virus.

Risk tolerance (green line) continued its decline last week while risk aversion (red line) continued to climb. The supply-and-demand balance for risk is now close to equilibrium, resulting in a mostly neutral risk appetite. We note that the decline in volatility has had less of an impact on sentiment in this region, and that investors remain mostly optimistic, with current risk tolerance levels driven by a desire to bet on the more risk-tolerant sectors in the market (i.e., risk appetite is driven by WANT, not NEED). This indicates that regional investors are more positive about the global economy, the recent rise in geopolitical tensions and the increase in local COVID-19 restrictions, than their peers in Europe or the US. But being brave in the face of low volatility means nothing if they run away? when volatility rises. Close monitoring of both their sector choices as well as the risk environment will be key to predicting where investor sentiment, and markets, go from here.