by Olivier d'Assier
Potential triggers for sentiment-driven market moves this week1:
- US: Deal or no-deal on debt ceiling, manufacturing PMI, consumer confidence data, jobs report.
- Europe: Inflation rates for the Eurozone, Germany, France, Italy, Spain.
- APAC: Manufacturing PMI data for China.
- Global: Partisanship in the debt ceiling deal between House Republicans and Democrats, and the start of the Spring counter-offensives in Ukraine.
Insights from last week’s changes in investor sentiment:
Investor sentiment continued to improve in most markets we track last week on the back of better-than-expected Q1 earnings reports. The only two markets where the recovery in sentiment was held back were Australia and the US. Elsewhere, sentiment became neutral to positive, restrained only by continued worries about high inflation/interest rates. Market risk has declined in Global Developed Markets and Global Developed ex-US markets2, reaching fresh year-to-date lows, allowing investors to become more risk-tolerant. In contrast, sentiment among US investors was held hostage by the (low) probability of a first-ever US default. Until a deal between House Republicans and the White House is done, signed, and delivered, investors are going to forget about the ‘next’ and the ‘before,’ and focus only on the present (US default).
The US market has been trending sideways since mid-April, unable to build on the rebound from the mid-March banking crisis lows engineered by the heavy-handed regulatory bailout of multiple mid-sized banks. As noted in our Equity Risk Monitor Highlights for the week of May 5, “the spread between the short-horizon statistical and fundamental forecasts in the US is now more than three percentage points, the highest it has been in at least 10 years”. This disagreement between the fundamental and statistical risk models suggests the presence of a non-fundamental risk factor (US default). Markets also lost momentum, indicating that something (US default) was bothering investors and that for some reason (US default) they could not become as risk-tolerant as their international peers. This persistent worry (US default) translated into a continued preference for risk-averse assets.
Over the past few weeks, the US government has had that exciting ‘Lord of the Flies’ feeling of being run by children3. In the end, it turns out, governing is two old white guys locking themselves up in a room to discuss a deal, weigh its merits, consult their respective oracles, and send white papal smoke out of the Capitol’s chimney when they feel the deal on the table is good enough for government work. After that, in a very public display of reverse codependency, an in-principle agreement was announced by both leaders via separate press conferences to avoid open conflict, and partially to claim innocence in the event of the finger. Investors may not be convinced that easily. Their new message to politicians for this week: “Do the thing. Because the talking about the thing isn’t the thing. The doing of the thing is the thing!“
Outside of the US, investors’ main concerns remain the fate of the global economy as central banks (ECB and Bank of England) continue to battle persistently high inflation. The German economy was the first to buckle under the current hawkish monetary policy, entering a technical recession last week with its second consecutive quarterly decline in GDP. This week’s inflation data for the Eurozone will set the mood for European investors, who are starting to see inflation’s resilience as a sort of defiance to the ECB. The central bank may very well react with further and larger interest rate hikes. For sentiment to improve further from here, moderation is the key, and we seem to be in desperately short supply of that everywhere.
Changes to investor sentiment over the past 180 days for the markets we follow:
How to read these charts: The top charts show the ROOF ratio (investor sentiment) in green (left axis), against the cumulative returns of the underlying market in black (right axis). The horizontal red line at -0.5 (left axis) represents the frontier between a negative sentiment (-0.2 to -0.5) and a bearish one (<-0.5), and the horizontal blue line at +0.5 (left axis) represents the frontier between a positive sentiment (+0.2 to +0.5) and a bullish one (>+0.5). In between those two lines, sentiment can be considered neutral (-0.2 to +0.2).
The bottom charts show the levels of both risk tolerance (green line) and risk aversion (red line) in the market. These represent investors’ demand and supply for risk. When risk tolerance (green line) is higher than risk aversion (red line), there are more investors looking to buy risk assets then investors willing to sell them (at the current price), forcing risk-tolerant investors to offer a premium to entice more risk-averse counterparts to take the other side of their trade, which drives markets up. The reverse is true when risk aversion (red line) is higher than risk tolerance (green line). The net balance between risk tolerance and risk aversion levels is used to compute the ROOF ratio in the top charts, representing the sentiment of the average investor in the market.
The blue shaded zone between levels 3-4 for both indicators represents a reasonable balance between the supply and demand for risk in the market. Conversely, when both lines are outside of this blue zone, the large imbalance in the demand and supply for risk can lead to an overreaction to unexpected news or risk events.
Jump to a specific market
Asia ex-Japan:
Australia:
China:
Developed markets:
Developed markets ex-US:
Emerging markets:
Europe:
Japan:
UK:
US:
1 If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.
2 See chart 7 in the Risk Monitors for Global Developed Markets and Global Developed ex-US Markets.
3 Rep. Dean Phillips (D., Minn.) said Democrats ultimately feel they have to be the “adults in the room.” WSJ.
