ROOF Highlights — October 18, 2021

Qontigo ROOF™ Score Highlights: Week of October 18, 2021

Potential triggers for sentiment this week1 :

  • US: Q3 earnings for IBM, Netflix, Tesla, Intel, J&J, and P&G. PMI, and industrial production.
  • Europe: Eurozone and UK PMI data, UK inflation and retail sales, and Eurozone consumer confidence
  • APAC: PMI data for Japan and Australia, BoC policy decision, and Q3 GDP data for China.

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:

  • Investor sentiment across global developed markets, the US, Europe and Japan weakened further last week, falling into or near the bearish zone (although Japan did recover somewhat in the last two days). In contrast, investor sentiment across global emerging markets, Asia ex-Japan and China strengthened further, rising to the upper region of the neutral zone.
  • The divergence between the two economic regions seems to be a temporal one, with the developed world far ahead in terms of vaccination rates and economic recovery than emerging markets. Developed-market investors worry about their rebound stalling while emerging-market investors are increasingly hopeful that rising vaccination rates will soon allow their economies to take off. Same bed, but different dreams, due to different bedtimes.
  • The bearish sentiment among developed-market investors has already caused a few isolated over-reactions from missed earnings and warnings about the impact of inflation on profit margins (e.g., FedEx Corp. -9.1%, Nike Inc. -6.3%, BB&B Inc. -22%, Delta Airlines -5.8%…). Increased dispersion among company statements is likely to define the Q3 earnings season, keeping investors on edge, and market volatility elevated.
  • Investors are incredibly adaptable, and this adaptability (repeatedly helped by unhealthy dozes of quantitative easing) has enabled them to thrive under different economic conditions. However, this adaptability can also be a weakness. In the last ten years, investors may have become habituated to temporary or benign inflationary pressures and may now fail to recognize them as a danger until it is too late.

US investor sentiment:

US investor sentiment (green line) fell deeper into the bearish zone (below -0.5) last week. Interestingly, when we remove the two volatility-related metrics from our methodology (“ex-Risk ROOF” – red dotted line), sentiment based solely on sector allocation seems to have paused just inside the neutral zone. This may help explain the divergence between markets (black line) and sentiment (green line) these past few weeks. As recent market volatility rose, investors were ‘forced’ to de-risk their portfolios, but rather than achieving this goal by selling risk assets, they seem to have opted to rotate into less risky sectors instead, and de-risk while remaining fully invested. This situation raises expectations even more for CEOs during this earnings reporting season.

The previous week’s gap between risk aversion (red line) and risk tolerance (green line) widened even more last week, further evidence of a declining risk appetite and an ongoing rotation into less risky sectors by investors. The imbalance between the supply and demand for risk assets is now large enough to cause a sharp over-reaction (downward) in the event of market-wide negative news. This is especially true during a quarterly earnings season as investors’ focus is on company-specific headlines instead of macro or geopolitical news. If a trigger for this bearish sentiment is to emerge, it is likely to come from the macro side and take investors by surprise.

European investor sentiment:

Markets seem to have provided the answer to the previous week’s question as to who is in the driver’s seat in Europe — markets or investor sentiment. Markets rose sharply last week in defiance of a declining sentiment. Unlike in the US, rising volatility was not to blame for a deteriorating sentiment in Europe.  The sentiment indicator without the volatility metrics (red dotted line), led the descent into bearish territory in the last four weeks, ending near the lowest year-to-date level. The divergence between markets and sentiment is now reminiscent of the late August situation, which led to a mutual convergence in September with markets declining as sentiment rose. Back then, however, sector allocations (red dotted line) pointed to a neutral risk appetite among investors. Recently, an ongoing rotation into less risky sectors points to rising risk aversion by investors, and it is pointing to a negative one now. A negative risk event at these levels would confirm investors’ bearish sentiment and lead to an over-reaction. In contrast, markets seem to have already priced in the possibility of a lack of a negative risk event, and this may only lead to a recovering sentiment rather than a new rally.

The gap between risk aversion (red line) and risk tolerance (green line) continued to increase last week, but the two remain within reach of each other. This moderate imbalance between the supply and demand for risk remains manageable, especially when compared to the highs of last March, June or September (which were all ignored by markets). Momentum, however, still seems to be on the side of risk aversion, and unless the recent rise in market volatility reverses, risk appetite may become increasingly negative.

Global developed markets investors sentiment:

The equilibrium reached between markets and investor sentiment last September seems to have ended last week, with market resuming their rise in defiance of a weakening sentiment. Markets last week were powered by the continued rotation into less risky sectors, as investors positioned themselves in alignment with an increasingly bearish sentiment ahead of the winter months. They seem to have abstained from de-risking their portfolios by simply disposing of risky assets and raising cash (i.e., they seem to lack the courage of their bearish conviction).

Risk tolerance (green line) and risk aversion (red line) diverged slightly more last week but remain well within the neutral range, especially when compared to their imbalance of March and early September. In the last month, while risk aversion has been rising, risk tolerance has remained flat, indicating here again that the rise in risk aversion may reflect a new penchant for defensive sectors rather than a dislike of risky ones. At these levels, investors seem to have become worried that inflation will impact markets, but are not yet pessimistic about its long-term impact.

Asia ex-Japan markets investor sentiment:

Markets in Asia ex-Japan seem to have heard the call from improving sentiment and rose sharply last week, but still have a long way to go before they catch up with the latter, which is heading for the bullish zone. Twice already this year sentiment entered the bullish zone, once in May and again in early July. Markets today are still more than 5% below the levels reached during both of those rallies. If sentiment can maintain its trajectory, markets should continue to retrace their September losses in the short term.

Last month’s rally in risk tolerance (green line) has flattened out this month, while risk aversion (red line) has continued its decline. This indicates that investors may need a few more reasons to become bullish but are becoming increasingly less bearish in the meantime. The balance between the demand and supply for risk is improving but only because investors are becoming less and less willing to part with risk assets rather than more and more willing to acquire additional ones. So, while the net risk appetite is rising, it is being powered by a single engine, not both.

Global emerging markets investor sentiment:

Emerging markets have ignored a rising investor sentiment since early September. Last week, as sentiment reached the top of the neutral zone, markets finally reacted and rose strongly. Sentiment is now back (up?) to the level of early July and seems to have recovered some momentum — perhaps poised to break into the bullish zone next week. If markets are now following sentiment, this could give them the impetus they need to recover their levels of June-July, some 5% higher than where they are now. Emerging markets are more sensitive to macro news than developed markets (as it affects commodity prices in particular), and so investor sentiment will take its cue from the impact that inflationary pressures are having on raw materials; specifically on fuel prices, which have a way of inflaming social unrest in parts of the global supply chain.

Risk aversion (red line) declined last week while risk tolerance (green line) rose, returning to their divergent routes of early September, indicative of a rising risk appetite.  The imbalance between them, however, has not yet reached a level where it would compel risk-tolerant investors to offer large price premiums to acquire more risk assets. Instead, if this growth in risk appetite can be maintained, we are likely to see a gradual rise in markets to their more recent highs. A greater imbalance in favor of demand will be needed for them to even recover the previous highs reached in June.