Potential triggers for sentiment this week1 :
- US: Q3 earnings for Pfizer, Moderna, Airbnb and Uber. Federal Reserve’s policy statement due Wednesday, US jobs report on Friday.
- Europe: Key factory data for Germany and France, and PMI data.
- APAC: Hong Kong Q3 GDP update, Australia trade data.
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 among developed-markets investors recovered from their recent bearish lows, to end the week at the border between neutral and bearish. At this level, it can be said that investors are no longer pessimistic but are not yet hopeful either.
- The recovery in sentiment can be credited to corporate CEOs, whose communication skills at calming investors dwarfs those of either technocrats or politicians. Despite earnings misses from three of the FAANGs (Facebook, Apple and Amazon), 82% of companies that have reported so far have exceeded expectations. European investors saw their raw nerves soothed by the ECB, which has openly maintained its easy monetary policy stance.
- Developed-markets investors have been playing defensive because of unease about a monetary policy error, reflecting a suspicion that central banker’s guesses about the longevity of inflationary and supply chain pressures are to econometrics what alchemy is to chemistry, or astrology to astronomy.
- Sentiment in the developing world continues to rise well ahead of YTD returns for their respective markets. The ROOF Ratio for global emerging markets, Asia ex-Japan and China are all high in bullish territory and getting stronger each successive week, yet market performance remains well below that of developed markets, with negative returns for global emerging markets and Asia ex-Japan.
- This leaves us with an interesting conundrum. Investors in those parts of the world that are skeptical and have implemented risk-off strategies, are seeing their doubts rewarded with above-average market gains. Meanwhile, investors in regions where sentiment is positive and have implemented risk-on strategies, have yet to be rewarded by markets at all – some might even say that they have been punished for their hubris.
- The lesson here seems to be that expecting a quiet upward market trend without preparing for a volatility spike or two, is like imagining sailing on the ocean without the prospect of a storm. Just because the equity market is (still) the only game in town, it doesn’t mean you dive in headfirst with your eyes closed without checking which end of the pool you’re standing on.
US investor sentiment:
US investor sentiment (green line) reversed all of October’s bearish move to end the month right where it started, at the border between worried and bearish. Receding concerns about the impact of inflation and supply-chain bottlenecks on earnings as well as declining market volatility allowed investor sentiment to bounce off its lows. Removing the impact from declining market volatility (red dotted line), sentiment ended the week flat, indicating no change to investors’ risk-off strategy via their sector allocation decisions. This earnings season was not a home run, though, and several warning shots about the Q4 season were fired by big guns like Apple and Amazon. This points to continued fragility in sentiment, especially as CEO voices recede and the noise from macro data and geopolitics rise. Who will reassure investors between now and January?
The previous week’s gap between risk aversion (red line) and risk tolerance (green line) narrowed last week, but remains largely in favor of the former, indicating that investors’ favorite strategy continues to be a risk-off one. A large part of this narrowing is due to declining market risk, which in turn has led to some unwinding of risk-mitigating positions. But ongoing sector allocation preference by investors points to a continued implementation of risk-off strategies for the time being.
European investor sentiment:
After a short foray into the bearish zone last week, sentiment among European investors recovered to end the week on the border between neutral and bearish. The catalyst for this reversal was the repeated assurance from the ECB that it will maintain its easy monetary policy and asset purchasing programs well into 2022. The impact from this unequivocal show of support was twofold: first, market volatility declined, allowing investors to unwind risk-mitigating trades. Second, the forward-looking sense of clarity it provided for the next few quarters enticed investors to start implementing some risk-on strategies in their sector allocation trades (red dotted line). So, are European investors turning bullish or is this just a knee-jerk reaction from a liquidity rally? (We note that the bond market doesn’t share the ECB’s carefree attitude towards inflation).
The gap between risk aversion (red line) and risk tolerance (green line) narrowed last week but remains large and negative enough to still cause a sharp overreaction on the downside if investors were spooked by any geopolitical shenanigans at one of this month’s several state summits. The European economic recovery is still weaker than the US one and although its monetary support is stronger, the months ahead will represent a serious test to the ECB’s tolerance for above-target inflation. There is an old cliché in economic circles on the interest rates and inflation relationship, about the tail wagging the dog. Investors may soon have to seriously consider what to do when it becomes clear that central banks are the tail, and the inflation is the dog who’s lost its leash.
Global developed markets investors sentiment:
Sentiment among global developed-markets investors halted its decent towards the bearish zone last week, ending straddled between the neutral and bearish zones, wishfully thinking things will not get worse than they fear. Central banks remain accommodative in the US, Europe and Japan, and CEOs during the Q3 earnings season have so far painted a benign picture of inflation’s grip on their margins, citing pent-up demand and a willingness from consumer to swallow higher prices. Nevertheless, as of last week, sector performance still describes an implementation of mostly risk-off strategies, suggesting investors remain invested but with a weary eye on the downside.
Risk tolerance (green line) and risk aversion (red line) halted their divergence but remain miles apart. The imbalance between the supply and demand for risk may not be as large as the previous week but is still large enough to cause an overreaction if risk aversion is triggered into action by negative news. The level of risk tolerance in the market is not high enough to absorb a large sell-off where investors would offload risk assets at discounts, weighing on markets. Conversely, absence of negative news from the various geopolitical gatherings and the macroeconomic front should lift the level of risk tolerance in the market, offering support for higher prices.
Asia ex-Japan markets investor sentiment:
The decline in market volatility in Asia ex-Japan helped investor sentiment soar to the upper echelons of the bullish zone last week (green line). Sector allocations (red dotted line) remained indicative of a positive sentiment but not as bullish as our risk-adjusted indicator. This is to be expected since sector allocation has been pointing to the implementation of a risk-on strategy by regional investors since late August, so, despite lower market risk, there isn’t much re-risking to be done in portfolios at this time. Unfortunately for investors, this continued risk-taking was not rewarded by markets, which chose to react to negative regulatory risk news out of China instead of positive global monetary policy news. Asia ex-Japan investors have implemented risk-on strategies at three different times YTD (March-April, May-June, and August-October) only to reverse course each time in the face of the market’s refusal to reward risk-taking. Will this time be different? Last week’s market move seems to say no.
Risk tolerance (green line) continued to surge last week while risk aversion (red line) declined further, leading risk appetite to reach its second-highest high this year after the April peak. But it seems that although investors are implementing risk-on strategies in response to improving economic fundamentals, markets chose to respond to political and regulatory stimuli instead. If continued supporting monetary policies by major central banks and a positive earnings season does not lift markets, then perhaps sentiment needs to recalibrate its focal point and become aware of the key drivers that are influencing markets to reward, or not to reward, risk-taking.
Global emerging markets investor sentiment:
Global emerging-markets investor sentiment (green line) responded positively to the promise of continued monetary support by major central banks, and lower market risk. Markets, on the other hand, suffered a setback from political and regulatory risks in both Latin America and China. As in Asia ex-Japan, global emerging markets remain easily spooked by regulatory moves and have been unable or unwilling to reward investors for risk-taking. Perhaps ten months of negative reward for risk-taking is enough and investors should think about switching to risk-off strategies as we head into the winter months.
Risk aversion (red line) halted its decline for now, while risk tolerance (green line) gave up some of its recent gain, indicative of a pause in investors’ growing risk appetite. At these levels, there is much more risk tolerance in the market than risk aversion, which should lead to an overreaction on the upside on positive news releases. Unfortunately for investors, what the market got instead was negative regulatory and political news, which seem to have triggered a risk-averse reaction in the form of a market sell-off instead of a simple rebalancing into a risk-off strategy. At this point, it seems that investors have chosen a ‘go-big-or-go-home’ strategy implementation and are not willing to rebalance to a risk-averse strategy, and would rather get out of the market completely than rotate into defensive sectors. Last week, some got out by offering steep discounts for their risk assets. What about this week? Now that the gig is up, risk-tolerant speculators may hold out for even bigger discounts the next time around.