ROOF Highlights — November 29, 2021

Qontigo ROOF™ Score Highlights: Week of November 29, 2021

Potential triggers for sentiment this week1 :

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:

  • Investing, to paraphrase Kierkegaard, can only be lived forward and reviewed backwards. Developed-markets investors have spent most of 2021 being half hopeful, but mostly scared. They hoped the effect of the pandemic was behind them, but were scared monetary and fiscal stimulus would end. Last Friday, what they worried about the least, scared them the most.
  • Investor sentiment ended the week at its low, with developed Europe and developed world investor sentiment narrowly avoiding a return to the bearish zone. Emerging-markets investors also curbed their enthusiasm, with Chinese investors ending their bullish run and falling to the neutral zone by the end of the week.
  • What’s next? The contrarian view sees the new viral threat to the recovering economy as raising the likelihood of continued stimulus and putting a (demand) break on inflation. For them, this means back to the Q2 2020 playbook and buying pandemic beneficiaries on the dip. The risk-averse investor will see the Omicron strain as putting even more stress on the global supply chain and inflation, leaving central bankers with few bullets to avoid a stagflation scenario. This means back to the March 2021 playbook for them, unwinding this year’s rotation trades, and de-risking their portfolios.
  • The new variant is only one piece of the puzzle for investor sentiment, the other piece is the response to this new health threat (i.e., lockdowns). China has been the most assertive on that front and will probably offer the first hint to investors as to the potential reactions from governments. The second hint will come from the scientific community with news of the effectiveness of existing vaccination protocols on the new variant. Finally, the third influence on sentiment will be how fast and wide this new variant spreads and local governments’ appetite for renewed social distancing restrictions at a time when opposition to them is at its strongest (i.e., has the Omicron variant cancelled Christmas?).
  • In short, a mild (social distancing) response backed by positive scientific news, will turn this risk event into a bargain-hunting opportunity. Conversely, a heavy-handed response caused by irresponsible (social) behavior and a sharp increase in new infection numbers will drive what little risk-tolerance is left among investors into hiding for the rest of the year. So, stay off the naughty list this holiday season and spread cheer, not fear.

US investor sentiment:

The recent recovery in investor sentiment (green line) was halted by news of the new Omicron variant of Covid-19. Despite the holiday-shortened week, investors were quick to implement risk-averse strategies (red dotted line) forcing sentiment back into negative territory. The sudden rise in market volatility is likely to drive more of them to de-risk their portfolios to protect year-to-date gains and remain compliant with their risk budgets. Investor sentiment in 2021 has been fragile at best and needed some positive news to give investors the confidence necessary to become bullish ahead of next year. They were focused on inflation, monetary stimulus, and their impact on the global economic recovery. No one seems to have seen Omicron coming. How bad it will get, and what authorities will do about it, will determine their risk appetite for the rest of the year.

Risk aversion (red line) and risk tolerance (green line) remained at equilibrium during the week. This coming week, fear might replace uncertainty as the main driver of sentiment and put risk aversion back in the driver’s seat, increasing the likelihood of overreactions to further negative news from the new variant. Look out for signs that will negatively affect the balance between the supply and demand for risk in the market from its current neutral position.

European investor sentiment:

European investor sentiment (green line) reversed the previous week’s recovery and headed back towards the bearish zone, ending the week just above it. Investors rotated out of the risk-tolerant strategies from the previous month, into risk-averse ones (red dotted line). Rising market risk is likely to increase (negative) sentiment’s momentum in the short term, driving it into the bearish zone as investors await further clues on the direction of the pandemic’s new chapter.

Risk aversion (red line) and risk tolerance (green line) have returned to their divergent path as uncertainty has grown with the arrival of the new variant on the global stage. The gap between them is still manageable in terms of the supply and demand imbalance, but the source of the uncertainty is unlikely to be resolved in the next week or so. Prolonged uncertainty, risking market risk, and the fact that we are entering the last trading month of the calendar year, puts momentum on the side of risk aversion in the short term. Risk appetite could be helped by news about the effectiveness of current vaccines on the new variant. Conversely, negative news on the scientific front, or in terms of social distancing measures being reimposed, will likely drive risk appetite to new lows.

Global developed markets investors sentiment:

Sentiment among global developed-markets investors (green line) had been somewhat weak since September and the short-lived recovery of the previous week was reversed by news of a worsening pandemic narrative. Sentiment ended down last week, just inside the neutral zone on the border with the bearish zone. Investors had implemented a rotation into more risk-tolerant sectors for the past month (red dotted line), but unwound part of those positions last week, driving demand for risk-averse sectors. Market risk will determine the direction of sentiment (green line) in the coming week with local government responses to the new variant driving investor demand for risk-averse or risk-tolerant sector allocations (red dotted line).

Risk tolerance (green line) and risk aversion (red line) ended their convergence last week, returning to a divergent path and signaling an increasingly negative risk appetite. The imbalance between the supply and demand for risk is now large enough to trigger a negative overreaction should the pandemic narrative worsen. Europe is already facing unrest from the few social restrictions still in place. The response to a tightening of these measures, especially ahead of the holidays, is likely to lead to more, not less, social angst, and drive risk appetite further into negative territory.

Asia ex-Japan markets investor sentiment:

Sentiment (green line) among Asia ex-Japan investors remains the highest among the markets we track. Frankly, we’re not quite sure why that should be. The region faces multiple tailwinds: a pile of high-yield debt under the threat of higher US interest rates and a stronger USD, a US-China relationship which seems to have deteriorated further instead of getting more predictable, a highly fragmented supply chain more at risk from the new variant than that of other regions, and regional government finances that are even more stretched than elsewhere after last year’s fiscal stimulus packages. The only positive is valuations, which remain low as markets have lost ground year to date. Pessimists will see sentiment as having only one direction to go from here (down), resulting in a market correction like the one experienced in Q2 of this year (-10%). Optimists will think stocks are cheap, and chances are low for a second year in a row of negative market returns, plus, there is no alternative. Whichever way you lean, just make sure to wear a mask while you’re doing it.

Overall, market sentiment remains high, but risk tolerance (green line) and risk aversion (red line) have been converging for a few weeks now, in a sign of bullish fatigue. Demand for risk seems to still outstrip the potential supply but momentum can change swiftly as we saw in May and August of this year. News of the new variant may affect sentiment for some time, and if the narrative remains negative, it has the potential to completely change investors’ risk appetite. For the last two months, risk tolerance has been higher than risk aversion, meaning investors have implemented bullish strategies since the start of September, driving up the valuation of risk-tolerance sectors. Risk-averse sectors, in contrast, now offer very attractive valuations. A switch to more bearish strategies will make them that much more attractive and help swing our sentiment index to a negative mood.

Global emerging markets investor sentiment:

Global emerging-markets investor sentiment (green line) has followed that of Asia ex-Japan investors for the past few months. Likewise, market returns have remained negative year to date, and the implementation of a bullish strategy is becoming increasingly expensive in terms of valuations. Increased market risk in the past two weeks caused sentiment (green line) to recede from its year-to-date high, but investors continued to favor risk-tolerant sectors (red dotted line). Declines in other markets is likely to force some investors to repatriate their funds from emerging markets to cover losses at home. This negative fund flow dynamic may trigger a rapid change in overall sentiment and force investors to rotate into risk-averse sector allocations.

The positive gap between risk aversion (red line) and risk tolerance (green line) continued to narrow last week but remains largely in favor of risk tolerance. The two factors that have kept sentiment somewhat stable recently have been a neutral fund flow and a flat market risk regime. Both are under threat with the latest pandemic development and could trigger a sharp increase in risk aversion among investors in a repeat of the reversal experienced from the beginning of June to the end of August 2021, when markets experienced a 10% correction.