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ROOF Highlights — June 20, 2022

Qontigo ROOF™ Score Highlights: Week of June 20, 2022

Potential triggers for sentiment this week1 :

  • US: Fed Chair Powell’s speech to Congress, flash PMI.
  • Europe: UK and Eurozone PMI, UK CPI.
  • APAC: Japan PMI and CPI.
  • Global: The ongoing fallout from the war in Ukraine will continue to dominate the headlines as investors anticipate Putin’s next move. Additionally, the US-China relationship is increasingly returning to center stage, this time with the more highly charged Taiwan issue as the main flashing point instead of trade.

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:

  • Sentiment remained negative in the US and developed Europe last week, and bearish in global developed markets. Hopes for further monetary and fiscal stimulus out of China managed to keep sentiment positive in Asia ex-Japan, global emerging markets and China, for the time being. Investors in Japan once again failed to turn bullish on their third attempt this year, ending the week neutral in a sign of growing discomfort with the Bank of Japan’s inaction in the face of rising inflation.
  • Back in 1913, the government of the United States established the Federal Reserve system with the simple goal of promoting economic and financial strength by engineering monetary policy to achieve maximum employment and price stability. Since February 2021, investors have been telling the Fed that inflation pressures were stronger than the central bank was willing to admit. This display of Munchausen splendor was aimed at getting a more serious monetary policy response. Last week, the Fed kindly obliged.
  • The focus of investors’ fears has now switched from central bank inactivity to the probability of recession, leaving them torn between regret and envy, their two principal emotions. Sentiment has been driven more by regret than envy since early 2021, resulting in the increased popularity of more risk-averse strategies. But perhaps it is only the case that after the longest bull market in history, which has produced gains in ten of the last 12 years, they have simply become more conservative now that they have more to conserve.
  • Between now and the start of the Q2 2022 earnings season in mid-July, the war in Ukraine will continue to be ground zero for investor sentiment. So far, the multiple visits to Kyiv by every “Perhapsburg” in Western Europe do not seem to have given Vladimir Putin a sudden case of bellum-interruptus, and hopes for an early end to this war have now faded. We seem instead headed into a summer of counterpunches that will force every CEO to detail their slipping maneuver with their guidance communication.
  • Valuations will be the name of the game over the next several weeks as investors adjust companies’ earnings outlooks — downward for most, upward for some —  in response to the new macroeconomic and geopolitical realities. The good news for stock-pickers is that this increased dispersion between winners and losers will provide some diversification benefits and a bigger opportunity set to apply their skill and fend off higher market volatility with better stock selection returns.

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US investor sentiment

The recovery in sentiment (green line) from the bearish levels reached in early May, paused last week, with sentiment ending little changed in negative territory. Investors got the long-awaited reaction to inflation they hoped for from the Fed, but are now worried about the rising probability of a recession and will focus on re-estimating fair value for their holdings. This will remain a guessing game for the next few weeks until the Q2 2022 earnings season gets under way, and they hear directly from CEOs about the impact on their businesses of the macroeconomic and geopolitical situation. There remains the fear that the Fed’s take on inflation does not guarantee success, and this possibility is preventing risk-aversion levels from dropping below risk-tolerance levels and keeping risk appetite slightly negative for the time being. Too many things can still go wrong, and an unusually hot summer is predicted ahead, which could add to both supply-chain and inflationary pressures in the near term.

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European investor sentiment

European investors’ sentiment (green line) has remained on a downtrend since the mid-May highs, and ended the week only slightly less negative than the previous week. In the near term, it is unlikely that developments in either inflationary pressures or the situation in Ukraine will provide any positives to drive sentiment upwards. More likely is that the data will point to growing evidence that the European Central Bank (like the Fed) has misjudged the severity and persistence of inflationary pressures and fallen behind the curve in fighting them. Adding to the macroeconomic and geopolitical pressures are the summer’s usual extreme weather events and social unrest — the former having already started in Spain. On the positive side, the balance between the potential supply and demand for risk is at equilibrium, which means investors are unlikely to overreact either way in the near term — that is, unless investors are given a good reason to do so.

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Global developed markets investor sentiment

Sentiment among global developed-markets investors (green line) ended the week bearish, unchanged from the previous period. Increased market and currency volatility is driving up hedging costs for investors, who continue to de-risk their portfolios ahead of an uncertain summer. The macroeconomic and geopolitical uncertainty has raised correlations across markets and eroded any diversification effects on multi-country portfolios, leading to a higher active risk for managers who also must contend with large currency swings and questionable earnings forecasts for the rest of the year. Global investors have been negative for over nine consecutive months now, and outright bearish most of that time. Risk-aversion levels remain well above risk-tolerance levels, indicating a still very negative risk appetite, and a dangerous imbalance between the potential supply and demand for risk in the event of more negative and unforeseen developments on either the macroeconomic, geopolitical, or climate-change fronts. The latter seems increasingly likely and may have already started in Spain and parts of the South and South-West US.

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Asia ex-Japan markets investor sentiment

Sentiment among Asia ex-Japan investors (green line) ended the week bullish, unchanged from the previous week. Investors continue to be uplifted by further talks of monetary and fiscal stimulus in China. Sector allocations (red dotted line) point to a shift in strategy implementation by investors, from a risk-averse stance previously to more risk-tolerant one now. Rising risk appetite is helped in part by low regional valuations compared to those of developed markets. Sentiment has risen for three consecutive months now, but market returns have yet to turn positive, leading many investors to question their ongoing commitment to a bullish scenario in the face of poor performance. Last week, the level of risk tolerance declined as much as the level of risk aversion, helping net sentiment end almost unchanged from the previous week, but this is hardly a rousing endorsement of the current bullish risk appetite.  

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Global emerging markets investor sentiment

Sentiment among global emerging-markets investors (green line) retreated last week from bullish the previous week to just positive, on the back of rising market volatility. Sector allocations (red dotted line) point to a continued implementation of marginally more risk-tolerant strategies for the first time since a two-week period in mid-February. This marks the third time since November 2021that investors have become more bullish, and each time markets failed to reward them with positive returns. The combination of the Fed’s faster pace of interest rate hikes, a stronger US dollar, and rising prospects of a global recession have kept markets down but have so far failed to bring down sentiment and turn risk appetite negative. This makes global emerging markets the exception rather than the rule, in that the risk-averse segment of the market is trading at lower valuations than the risk-tolerant segment, which has been more popular with investors since late March. Now might be a good time to rotate into risk-averse stocks and out of risk-tolerant ones.

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Japan market investor sentiment

Sentiment among Japanese investors (green line) declined sharply last week, ending neutral after failing yet again to become bullish. Sentiment first surged from its bearish levels of mid-March, on news of the upcoming reopening of the Chinese economy post COVID-19 restrictions, and helped by a rapidly weakening yen. Failure to become bullish since mid-April has kept markets range-bound for the past two months. Risk-aversion levels, meanwhile, have retraced half of their April drop and have risen to be on par with risk-tolerance levels, which fell sharply last week. Risk appetite is now neutral, showing a lack of confidence in the BoJ’s current strategy of ignoring inflation and maintaining their “unlimited bond purchasing program”. It would seem that equity investors are not buying Governor Kuroda’s sales pitch that inflation is good for the Japanese economy.

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China (domestic) investor sentiment2

Sentiment (green line) among Chinese (A-shares) investors remained positive last week, rising slightly from the previous week. Continued communication around further monetary and fiscal stimulus to ensure a broader economic rebound that would include the consumer discretionary sectors of the economy lifted sentiment. The pro-growth stance of the authorities keep underpinning investors’ risk-tolerance levels, but risk-aversion stayed at current levels due to rising US-China tensions. While overall sentiment improved, sector allocations (red dotted line) still point to the implementation of cautiously optimistic strategies, and not bullish ones yet. We note that the last time risk tolerance was this high (above 4.0 in the lower chart), risk aversion was much lower (at 2.5) versus where it is now (just below 3.5). So it would seem that investors have given authorities the benefit of the doubt until now, but would like to see some details behind their reflation plans before taking on more risk.   

2 Note that as of the end of May 2022, we have switched to using a core benchmark as estimation universe instead of the broad market portfolio to better capture the behavior of institutional investor by removing the small caps from our analysis.

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