Potential triggers: US, UK, Eurozone, Japan, and Australia PMI data. BoE policy meeting. US durable goods orders and Q1 GDP (final). UK and EU consumer morale.
Summary: Sentiment continued to improve last week across all markets we track except China, which saw a small decline (albeit from a very high base). US investors recorded the largest increase in sentiment, crossing over into bullish territory (>+0.5). European investors, meanwhile, pared some of their recent risk aversion to end the week just inside the neutral zone. As we cautioned in a recent blog post, the bulk of the recent improvement in sentiment has been driven by declining market volatility and not by a penchant for the riskier segments of the market. As market volatility changes course and begins to rise, this reason to buy can quickly turn into a reason to sell, and with the lower volumes during the summer months, risk aversion can rise very quickly. As investors globally reassess their earnings forecasts given the earlier prospect of higher US interest rates (and the reality of a stronger USD), we are likely to see a pause in both markets and sentiment until the Q2 earnings season begins. At current levels, though, the cognitive bias is sufficiently positive to withstand some negative news and remains more likely to over-react to positive ones.
US investor sentiment reaches YTD highs but hints at hubris
Both ROOF Ratios surged to YTD highs last week driven mostly by the two volatility metrics in our methodology (top chart). The recent rise masks the fact that investors remain focused on inflation and favor risk-averse styles and sectors. The strongest sentiment YTD may therefore simply be a hubristic feeling of invincibility driven by the low probability of losses from declining volatility. The ROOF ratio ex- the two risk metrics shows sentiment dipping even lower at -0.68 last week.
Risk aversion (red line) and risk tolerance (green line) have now completely reversed their position from just one month ago in the fastest turnaround we’ve seen this year (bottom chart). As mentioned above, however, were it not for the declining volatility, risk aversion would still be higher than risk tolerance, even increasing its lead last week, signaling that investors are more cautious than they appear to be.
European investor sentiment halts its decline but remains weaker than markets suggest
European investor sentiment recovered last week from its short dip into bearish territory but remains much weaker than the recent market’s defiant rise suggests (top chart). As in the US, this recovery is mostly due to declining volatility last week and rising volatility this week will return sentiment to its downward path. If markets finally take their cue from sentiment, we could see the erosion of the May-June rally. At these low levels, sentiment is quite susceptible to over-reaction to negative news and, given the low volume of the summer, could take markets down sharply.
Risk aversion (red line) remains higher than risk tolerance (green line) despite last week’s reversal (bottom chart). The gap between supply and demand for risk still suggests higher downside momentum than upside potential for markets if negative news triggers risk-averse investors into action, creating an oversupply of risk assets in the market.
Sentiment of Global Developed and Asia ex-Japan investors remains bullish
Global investors remain bullish but, unlike their US and EU counterparts, their optimism is not driven by the declining volatility environment of the last few weeks alone, but by a solid preference for risk-tolerant styles and sectors as well (top chart). This stronger foundation for optimism may better protect global markets from downside than their domestic or regional counterparts, as rising volatility alone will not be enough to erode confidence.
Likewise, investor sentiment in Asia ex-Japan has also reached fresh YTD highs and has been supported by a more genuine bet on risk-tolerant styles and sectors than in the US or Europe (bottom chart). Rising volatility could temper this enthusiasm but the trend remains on the upside, and with Asian markets having underperformed, there is not much profit-taking to be had but a lot of upside potential if bullish sentiment holds.
Sentiment in both Japan and China takes a step back but remains in the bullish zone
After shooting up the previous week, sentiment in Japan retraced its steps but ended last week still inside the bullish zone (top chart). The decomposition shows more vulnerability for Japan to a change in the direction of volatility, but markets have not run away from sentiment there as much as they have in Europe. Therefore, if positive sentiment persist, downside risk may be limited.
Chinese investor sentiment weakened a little bit more this past week, in sympathy with the rest of the world, but remains firmly in the bullish zone (bottom chart). Investors in that market have favored risk-tolerant styles and sectors for some time now but have yet to be commensurately compensated as the STOXX China A 900 remains well below its highwater mark of February 2021. Note that the China A market volume remains predominantly driven by retail investors, who do not adopt style or sector strategies. The ROOF Ratio, therefore, captures the mood swings of the minority institutional investors in that market and is sometimes at odd with those of retail investors.