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ROOF Highlights — November 22, 2021

Qontigo ROOF™ Score Highlights: Week of November 22, 2021

Potential triggers for sentiment this week1 :

  • US: FOMC minutes, personal consumption and expenditure, PMI data, Fed chair announcement (Powell vs. Brainard?).
  • Europe: PMI data, new coronavirus-related restrictions if numbers worsen.
  • APAC: PMI data for Japan and Australia, Bank of China prime rate decision.

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 continued its timid recovery from bearish to neutral last week, with Japanese investors attempting a solo ascent on the bullish zone. The radix malorum for sentiment remains inflation and its potentially negative impact on the global economic recovery as a trigger for tighter monetary policy.
  • Sentiment among emerging-market investors, meanwhile, remained bullish, focused on rising consumer demand in developed economies and expectations of incoming fund flows from global investors. Markets, however, have yet to reciprocate the feeling with positive returns, and while risk-on strategies are faring better than risk-off ones, fear-of-missing-out is still being rewarded with negative returns.
  • The great rotation trade towards sectors that were victims of, and escapees from, lockdown measures imposed last year, may have reached the point of diminishing returns for developed-markets investors. New COVID-19 infections are flaring up here and there, and only a medical cretin would think lockdowns are a thing of the past as the Northern hemisphere winter starts.
  • In their last meetings, central banks have extended a somewhat feline paw towards investors promising to slowly unwind their asset-purchasing programs first, before thinking about raising interest rates. There are times when inflation is too strong not to be stood-up to, and others when its bluff can be called. Investors seem unsure how this game of chicken will end, but are willing to give central bankers the benefit of the doubt for now.

US investor sentiment:

The combination of a decline in market volatility and signs that supply-chain issues might not derail the Christmas shopping season helped US investors sentiment (green line) recover sharply last week to end in a perfectly neutral position ahead of a holiday-shortened week. The fragility of the outlook for both inflation and COVID-19 disruptions, however, means that the wheels of sentiment are unlikely to turn bullish without a healthy supply of either fiscal or monetary grease (preferably both). In the short term, a benign sentiment should translate into a sideways market.

Risk aversion (red line) and risk tolerance (green line) bolted towards one another to end the week in perfect equilibrium. The potential supply of risk now equals the potential demand, thereby isolating the market from any overreaction to either negative or positive news in the short term. Despite a neutral risk appetite, the bias is still on the positive side given the continuous supply of new liquidity from ongoing QE programs and the ongoing lack of alternatives to equities.

European investor sentiment:

European investor sentiment (green line) recovered sharply last week to end just inside the neutral zone, erasing a month-long bearish mood. As pointed out in last week’s commentary, the sector allocation signal (red dotted line) has been pointing to the implementation of more risk-tolerant strategies by investors since mid-October, and what was holding sentiment back was the rise in market risk. Last week’s decline in market volatility helped sentiment continue its recovery, but with Europe being the epicenter of a new wave of COPVID-19 infections and possible lockdowns, market risk could easily flare up again, forcing risk-aware investors to de-risk their portfolios by implementing risk-averse sector allocations. The STOXX Europe 600 has risen some 10% since sentiment turned negative in October and could easily give up those gains if consensus turns to risk aversion.

Risk aversion (red line) and risk tolerance (green line) sharply narrowed their gap last week, ending near equilibrium. The fall in risk aversion was faster than the rise in risk tolerance and mostly driven by the decline in market risk. If the COVID-19 situation takes a turn for the worse and more countries talk about renewed lockdown measures, sentiment could make a 180-degree turn towards sharply rising risk-aversion and drive risk appetite back into negative territory. Conversely, not much is on the agenda for a potential positive surprise, especially with winter coming.

Global developed markets investors sentiment:

Sentiment among global developed-markets investors (green line) made a sharp U-turn for the better last week, ending just inside the neutral zone. Markets have been held back by a deteriorating sentiment since late October, despite the implementation of increasingly risk-tolerant sector allocations (red dotted line). An improving sentiment could help them reach new highs, but it will take another week or two of a similar surge in sentiment for risk tolerance to drive a sustainable market rally. With many US investors away on holiday this week and Europe struggling to contain a new wave of infections, odds are that in the short term, sentiment will remain in the neutral zone, capping any market advance.

Risk tolerance (green line) and risk aversion (red line) converged sharply last week on falling market risk and a renewed penchant for risk-tolerant sectors. The gap between the two remains large, however, and still in favor of the potential supply of risk rather than demand for it. At these levels, risk appetite remains negative and it will take more than a single week of improvement to convince investors that sentiment is on a sustainable uptrend.

Asia ex-Japan markets investor sentiment:

Sentiment (green line) among Asia ex-Japan investors remains bullish without showing signs of risk-tolerance fatigue. Markets continue to resist sentiment, remaining negative year-to-date, and continue to show signs of being supported only by the absence of negative news rather than the presence of positive ones. The eagerly awaited fund flows from developed-market investors have so far failed to show up, preferring, and being rewarded for, staying home instead. In short, Asia ex-Japan seems to be a third-world region with a first-world problem.

Risk tolerance (green line) and risk aversion (red line) narrowed their gap slightly last week from its recent high but remain strongly in favor of risk tolerance, indicating that despite negative year-to-date returns, risk-on strategies are still outperforming risk-off ones. The two metrics supporting this positive risk appetite are a lower level of market risk and low valuations due to strong earnings forecasts. Both metrics are at the mercy of a worsening COVID-19 situation in the coming months or the need for the Federal Reserve to start raising interest rates sooner than planned, which would have a knock-on effect on the region’s high-yield bond market.

Global emerging markets investor sentiment:

Global emerging-markets investor sentiment (green line) remained high for the third week in a row. Markets have yet to reward this bullish sentiment, having ended the week in negative territory. The fundamentals seem to be in sentiment’s favor, with low US interest rates, positive consumer demand, ongoing fiscal stimuli, and a mostly peaceful geopolitical atmosphere. These circumstances usually benefit emerging markets, yet the STOXX Global Emerging Markets 1500 index stands at -4% year to date, making emerging markets one of the worst performers. It would seem as though the QE-induced liquidity is simply gravitating towards the regions with the biggest stimulus packages – i.e., developed markets. Fund flows may be redirected towards emerging markets’ low valuations once fiscal stimulus ends, but not after monetary policy tightens. That’s a very short window.

The positive gap between risk aversion (red line) and risk tolerance (green line) narrowed slightly last week but remains well in favor of risk tolerance, meaning that emerging-markets investors continue to favor risk-tolerant sectors over risk-averse ones. This is indicative of the implementation of mostly bullish investment strategies, with risk-off strategies continuing to underperform even as markets refuse to reward risk-on portfolios with positive returns. As such, emerging-markets investors have little choice: either believe in the optimistic view or underperform. A bullish sentiment may therefore represent a lack of option rather than a deliberate choice.