ROOF Highlights — March 1, 2021

Qontigo ROOF™ Score Highlights: Week of March 1, 2021

Potential triggers this week: The US Senate votes on Biden’s proposed $1.9 trillion fiscal stimulus package. On the data front, the US Jobs report Friday and global manufacturing and services sector PMI data throughout the week.

Summary: Every market we track except the UK and Australia have seen a further deterioration in sentiment. In Japan and Asia ex-Japan, the Sector ROOF ratio has now slipped into bearish territory. The decline in sentiment is not new, however last week, markets finally heeded the call and declined in-line with sentiment. It appears markets had been focusing on the positive impact the $1.9 trillion the US fiscal stimulus package will have on earnings, while sentiment has been looking ahead and worried that today’s reflation could turn into tomorrow’s inflation (worst – stagflation if it doesn’t work). As sentiment weakens, the cognitive bias becomes increasingly negative and looks for confirmation bias in data releases. This week will see the US Senate vote on the $1.9 trillion stimulus package, and Friday will see the all-important US Jobs report for January. A delay in the stimulus and a strong employment report could send investors running for the exit. Conversely, a smooth passage of the bill and a weak jobs report might turn sentiment around, in the short-term.

Market gives in to sentiment – profit-taking or a new direction?

Markets’ divergence with sentiment ended last week when the former headed lower (top chart). Both ROOF Ratios ended the week lower than the previous one as sentiment continues to decline and seems headed for the bearish zone. As of now, this is reminiscent of the September-October 2020 period when sentiment which had been declining since July started to weigh on markets. What followed was two months of up-and-down markets before the US election results boosted sentiment again with increasing confidence that a larger second stimulus package would be passed by congress. The difference this time around is that investors fear repeated monetary and fiscal stimuli will have unintended inflationary consequences. Risk tolerance (green line in bottom chart) and risk aversion (red line in bottom chart) had been at equilibrium for the past month but now seem to be giving risk-aversion the upper hand, driving risk appetite lower.

European markets decline, weighted down by a deteriorating sentiment.

Sentiment among European investors has now fallen deep into the neutral zone seemingly headed for bearish territory (top chart). Sentiment, which had been weakening since mid-January, weighed on markets last week with both ending below their previous week’s close. As we saw in Q2 and Q3 2020, sentiment tends to lead markets in Europe. Is the current situation more like Q1 2020 when markets simply traded sideways on weaker sentiment, or is it more like Q3 2020 when sentiment dipped into the bearish zone inducing a 10% market correction in the process?

The supply and demand for risk is now back at equilibrium (bottom chart) with risk tolerance (green line) and risk aversion (red line) almost at the same level. As sentiment weakens, investors will start to give more weight to negative news than positive ones. If sentiment enters bearish territory, the negative cognitive bias will trigger an over-reaction to negative news and further market correction.

Global and Asia ex-Japan markets succumb to a rapidly declining risk appetite.

The STOXX Global 1800 declined last week following an increasingly negative risk appetite (top chart). We saw a similar pattern back in September-October 2020 and it took news of multiple COVID-19 vaccines, a positive US election result, and improving post-Brexit trade talks to return sentiment to a positive bias. This time around, we have inflation fears, much higher US treasury yields, and still many parts of the world under severe safe distancing measures.

Risk aversion (red line in bottom chart) in Asia ex-Japan has continued to rise last week, reaching its highest level in 12 months. Risk tolerance (green line in bottom chart) meanwhile, has hit a new low making the supply and demand balance for risk strongly in favor of risk-aversion in that market. In this situation, the many risk-averse investors far outnumber their few risk-tolerant peers. If a negative news triggers these risk-averse feelings into action (i.e., selling), the ‘many’ will have to offer the ‘few’ large price discounts to de-risk their portfolios (i.e., why markets fall). Like other markets, Asia ex-Japan was able to avoid this fate back in October last year, but the imbalance is greater this time around and inflation worries is an additional concern for investors now.