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Potential triggers for sentiment-driven market moves this week1:
- US: Speeches by Fed officials and data on retail sales, housing starts, home sales, and industrial production. Earnings from Tesla, Bank of America, Johnson & Johnson, Procter & Gamble, and Netflix.
- Europe: UK inflation, unemployment, and retail sales data. Germany’s economic sentiment index and PPI data.
- APAC: China Q3 GDP, industrial production, retail sales and unemployment data, BoC new loan prime rate decision. Japan inflation data. Australia labor data for September and minutes of last week’s RBA rate decision meeting.
- Global: Impact of the ongoing Israel–Gaza conflict on energy prices, inflation, monetary policy, and economic outlook.
Insights from last week’s changes in investor sentiment:
Investor sentiment declined last week in all markets we follow except China, where investors returned from a week-long holiday to the sound of “further stimulus is coming”, boosting their mood from neutral to positive. Sentiment in the UK also bucked the trend by remaining neutral. Elsewhere, investors turned bearish in Global developed markets, Global developed ex-US markets, and Europe. Sentiment ended the week very negative in the US and Japan, just a couple of points shy of bearish. Sentiment in Australia has also declined, reverting to neutral from positive the previous week. Investor sentiment is affected by two things: market volatility (how big their returns can be), and uncertainty (how hard it is to predict the sign of those returns). Two weeks ago, volatility was low and uncertainty was on its way down as we neared the top of the interest rate cycle. Last week, both shot up.
When macro uncertainty is high and confidence in return forecasts is lacking, investors become more prone to adopting a popular narrative as true, especially if this narrative has a contagious element to it, combined with a spirit of “us (investors) Vs them (the Fed)”2. In 2021 the rapidly spreading narrative was that the Fed, by ignoring inflation, was literally going to make us pay the price. In 2022 a new narrative described a vengeful Fed raising interest rates to punish the economy into recession. As the most anticipated recession in history turned into the most postponed recession in history, a new narrative evolved in Q3 of 2022. The Pivot narrative included plots of rescue (for the economy), pursuit (of inflation), and escape (for investors), making it very infectious and boosting its contagion effect. By the end of January 2023, it had gone viral.
Contagion can weaken with time (fewer investors left to ‘infect’) and with new information that either contradicts the narrative or takes investors’ attention in a new direction (cue dependent -forgetting), so that the narrative seems less and less connected to with the current situation. In March 2022, the Fed admitted that it had been wrong about inflation being temporary and announced it would start tightening credit conditions to slow the economy down. This negated the inflation narrative of 2021 and gave birth to the new recession narrative of 2022. In August 2022, it only took two consecutive monthly declines in the headline inflation rate, to position the Pivot narrative as the natural successor to the recession narrative; wishful thinking enhances contagion.
In February 2023, stories of a resilient economy started chipping away at the ‘rescue’ plot in the Pivot narrative; the economy, it seemed, did not need rescuing. Subsequent testimonies by Fed officials that a pivot was not on the cards until inflation was confidently on its way to 2%, further eroded the ‘pursuit’ plot. But still, the Pivot narrative survived, in the absence of a credible successor.
The tragic events still unfolding in Israel will continue to be emphasized by the media and increase the already high level of uncertainty for investors. Will the conflict broaden into a regional conflict? Will oil prices surge? Natural gas prices? Heating oil prices? Will the current “higher-for-longer” consensus on interest rates become “even-higher-until-it-breaks”? These worries will chip away the Pivot narrative’s ‘escape’ plot, and without its happy ending, it will find it harder to ‘infect’ new investors.
The question now is what type of story will capture the hearts and minds of investors next. Put simply, when investors are bullish and uncertainty is high (i.e., they don’t quite know why they should be bullish), they are more likely to believe in fairy tales, but when they are bearish and uncertainty is high (i.e., things could be even worse than they think), they are more easily scared by horror stories. Let’s face it, right now investors have about as much chance in predicting the economy correctly as they have in choosing their airline seat when redeeming frequent-flier miles to travel on a holiday weekend.
Russia is at war with Ukraine. NATO is in a sanctions war against Russia. US-China relations are deteriorating. The US and Europe are (still) arguing about steel tariffs from the Trump era. The middle east has a new armed conflict. And winter is coming. 2024 is a Presidential election year in the US, meaning that every candidate must appear tough on foreign enemies – no détente allowed – and model their immigration policy on some version of “keep your tired, your poor, your huddled masses yearning to breathe free”. Jamie Dimon may have been on to something last Friday when he said, “now may be the most dangerous time the world has seen in decades”. Doomsayers are already working on stories with plots about ‘sacrifice’ (for consumers), ‘transformation’ (for the economy), and ‘rivalry’ (for politicians). Volatility may be low, but uncertainty is high, and the latter is likely to extend the outperformance of Risk-Off strategies over Risk-On ones that started in Q3.
Changes to investor sentiment over the past 180 days for the markets we follow:
How to read these charts: The top charts show the ROOF ratio (investor sentiment) in green (left axis), against the cumulative returns of the underlying market in black (right axis). The horizontal red line at -0.5 (left axis) represents the frontier between a negative sentiment (-0.2 to -0.5) and a bearish one (<-0.5), and the horizontal blue line at +0.5 (left axis) represents the frontier between a positive sentiment (+0.2 to +0.5) and a bullish one (>+0.5). Around the horizontal grey line at 0.0 (left axis), sentiment can be considered neutral (-0.2 to +0.2).
The bottom charts show the levels of both risk tolerance (green line) and risk aversion (red line) in the market. These represent investors’ demand and supply for risk. When risk tolerance (green line) is higher than risk aversion (red line), there are more investors looking to buy risk assets then investors willing to sell them (at the current price), forcing risk-tolerant investors to offer a premium to entice more risk-averse counterparts to take the other side of their trade, which drives markets up. The reverse is true when risk aversion (red line) is higher than risk tolerance (green line). The net balance between risk tolerance and risk aversion levels is used to compute the ROOF ratio in the top charts, representing the sentiment of the average investor in the market.
The blue shaded zone between levels 3-4 for both indicators, represents a reasonable balance between the supply and demand for risk in the market. Conversely, when both lines are outside of this blue zone, the large imbalance in the demand and supply for risk can lead to an overreaction to unexpected news or risk events.
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Developed markets ex-US:
1 If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.
2 I do not mean to imply that investors are easily swayed by falsehoods, simply that narratives are “human constructs that are mixtures of fact and emotion and human interest and other extraneous detail that form an impression on the human mind” (Shiller 2017).