by Olivier d'Assier
Potential triggers for sentiment this week1 :
- US: Inflation and consumer confidence data.
- Europe: UK’s Q3 GDP, German foreign trade.
- APAC: Chinese inflation 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-market investors decoupled last week, with US and Japanese investor sentiment continuing to recover from the bearish lows seen in October. In contrast, sentiment among both European and global developed-market investors halted its recovery and retreated to the bearish zone, ending the week at new recent lows in both regions.
- Sentiment remains aligned and rising among global emerging, Asia ex-Japan, and Chinese market investors, reaching new bullish highs. Markets in these regions, though, have yet to reward risk-taking for investors and continue to be dismissive of their risk-tolerant attitude. The risk for investors in these markets is that they become addicted to overplaying their own hand as markets continue to reward risk-taking with negative absolute returns (even if, in relative terms, risk-averse strategies are faring worse).
- The Q3 earnings season is almost behind us now and has had a positive effect on investor sentiment in most markets except Europe and global developed markets. Central banks confirmed their pro-growth stance, for now, and additional fiscal spending is on the way; both should continue to provide tail winds for sentiment and markets in the short term.
- The risk to sentiment in the next three months will come from the still fluid COVID-19 situation, as well as geopolitical conflicts (e.g., military build-up between Russia and Ukraine, China and Taiwan, fishing rights between the UK and France, US-China trade relations, etc.). Sentiment remains soft across the developed world, and in the US investors have seen risk-off strategies outperform risk-on ones as well as the broad market all year.
US investor sentiment:
US investors sentiment (green line) continued to recover last week, helped in part by declining market volatility, as well as an overall strong Q3 earnings season and an improving employment situation. Sentiment remains on the weak side, though, and absent a sharp decline in market risk, the recovery isn’t as spectacular as it first seems (red dotted line). Still, with 82% of companies reporting better-than-expected results for Q3, labor-market supply constraints seemingly easing, passage of the $1.2 trillion infrastructure bill, and ongoing negotiations for a further $2.0 trillion social-spending and climate bill, sentiment should continue to recover and support further market upside. The only risk to this scenario would come from domestic and global politics, especially as corporate America goes radio silent for the next three months until the next quarterly earnings season starting in January 2022.
Risk aversion (red line) declined further last week and at a faster rate than the rise in risk tolerance (green line). This difference indicates that a lot of the improving sentiment picture might be driven by the continued unwinding of risk-mitigation trades rather than the opening of risk-taking ones. Still, if nothing comes out of the geopolitical wing to cause a volatility spike, the balance in the supply and demand for risk assets should continue to gradually improve, removing the threat of large and sudden drawdowns for investors in the short term.
European investor sentiment:
The emotional support from the previous week’s assurance by the ECB for continued easy monetary policy was short-lived and sentiment (green line) among European investors retraced its steps, falling deeper into the bearish zone last week. In contrast, absent the recent rise in short-term market risk, sentiment based on sector allocation alone (red dotted line), seems to have continued to improve, in a sign that investors may still be implementing more risk-tolerant strategies. The declining volume these past two weeks provides an explanation for this divergence of intent as more investors chose to remain on the sideline as a risk-mitigating tactic rather than implement a risk-averse strategy.
Risk aversion (red line) and risk tolerance (green line) moved further apart last week, opening a large imbalance between the potential supply and demand for risk in the market. The gap is once again large enough to cause a sharp drawdown should negative news trigger risk-averse investors into action, forcing them to offer large price discounts to offload assets.
Global developed markets investors sentiment:
Sentiment among global developed-markets investors (green line) weakened late last week to end just inside the bearish zone, reflective of a recent rise in short-term market risk. Absent the rise in risk (red dotted line), sector allocation continues to reflect an improving sentiment as investors reduce their exposure to risk-averse sectors in favor of risk-tolerant ones. The increase in average daily volume last week seems to confirm greater investor participation, giving the hypothesis of an improving sentiment more weight. It may be that investors are unwinding risk-averse positions but not yet implementing a risk-tolerant strategy via their sector allocation decisions. This would be consistent with a sentiment that is not yet pessimistic but no longer hopeful enough.
Risk tolerance (green line) and risk aversion (red line) resumed their divergence last week, increasing the imbalance between the supply and demand for risk in the market. This negative risk appetite opens the possibility of a large drawdown in the event of a negative news triggering risk-averse investors into action. The imbalance is not as large as the late August levels that helped drive the September market decline, but large enough to cause a 5%-10% correction. Conversely, a contrarian strategy would see the current imbalance favorably as repeated positive news could replace a need to sell with a need to buy, forcing investors to offer large price premiums to acquire more risk assets as they rush to implement a more risk-tolerant strategy in their portfolios.
Asia ex-Japan markets investor sentiment:
Sentiment (green line) among Asia ex-Japan investors has reached the over-confident and over-optimistic level of the bullish zone. In this state, investors are demonstrating a disregard for negative news and are likely to rationalize it away, responding only to positive news. Even taking away the recent decline in market risk, the sector allocations (red dotted line) confirm the ongoing implementation of predominantly risk-tolerant strategies by regional investors. Markets, meanwhile, after initially rising with sentiment in early October, have declined since then and continue to diverge away from sentiment in November. This divergence means that although market returns are negative for both, risk-tolerant sectors are outperforming risk-averse ones.
Risk tolerance (green line) flattened out last week while risk aversion (red line) continued to decline, bringing the current risk appetite to its highest-level this year. We know from the active returns of risk-tolerant sectors that they are outperforming those of risk-averse sectors, which tells us that investors continue to favor being risk-tolerant at this point in the economic cycle. Year-to-date, this risk appetite has not been rewarded in absolute terms but despite the market’s negative returns, a risk-averse strategy would have done even worse. How long investors will continue to hold this view depends on the market rewards for the alternative, which remain negative so far in 2021.
Global emerging markets investor sentiment:
Global emerging-markets investor sentiment (green line) rose again last week as they continue to implement risk-tolerant strategies. Broadly speaking, as is the case in Asia ex-Japan, by chasing risk-tolerant sectors, those are outperforming risk-averse ones, despite absolute returns being negative year-to-date. This signifies that global fund flows are still favoring developed markets and that although the money remaining in global emerging markets is risk tolerant, it isn’t enough to lift the broad market and secure positive returns for investors. If news emerges to redirect fund flows towards emerging markets, then portfolios with a risk-tolerant exposure will be rewarded in absolute terms as well as relative ones.
Risk aversion (red line) continued to decline, while risk tolerance (green line) ended the week higher after a hesitant start. Investors’ indecision in gaining further exposure to risk-tolerant sectors is understandable given the lack of absolute returns this year — they cannot live on relative returns alone. Still, unless global fund flows return to emerging markets, it is hard to see how this strategy will have a happy ending, especially with projections of higher US interest rates next year and rising credit default risk.
