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ROOF Highlights — October 23, 2023

Qontigo ROOF™ Score Highlights: Week of October 23, 2023

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Potential triggers for sentiment-driven market moves this week1:

  • US: Q3 GDP growth rate, PCE Price index, personal income and spending, durable goods orders, and PMI data. Fed Chairman Powell’s speech Wednesday. Earnings from Alphabet, Microsoft, Meta, Amazon, 3M, Coca-Cola, GM, and Spotify.
  • Europe: ECB interest rate decision (expecting no change), and Eurozone consumer confidence.
  • APAC: Japan October PMI and Tokyo CPI data. Australia Q3 CPI and MPI data.
  • Global: Impact of ongoing conflict in Israel on oil prices and bond yield (and indirectly on inflation and interest rate policy).

Insights from last week’s changes in investor sentiment:

Investor sentiment declined further last week in light of the ongoing conflict in the middle east, rising oil prices, and surging treasuries yield in the US. Investors are now bearish in seven of the ten markets we follow, neutral in two (Australia and the UK), and positive in only one (China), where hopes for a further stimulus package from the authorities is keeping investors waiting patiently, it seems. Rising volatility and uncertainty from ongoing geopolitical events with binary outcomes (Israel, Ukraine, US-China), has sharply lowered investors’ confidence levels, converting return forecasts into assumption-filled guesses and increasing the likelihood of an emotional overreaction to negative news.

The mind is biased to the easiest conclusion. When sentiment is bearish and uncertainty is high, a negative interpretation is the easiest to jump to. News, however, is never unequivocally good or bad, context is key. In the US, the Fed is trying to midwife a recalcitrant economy into a soft-landing by making consumers risk averse, without triggering their risk aversion. In Europe, the ECB is navigating inflation’s mood swings without inadvertently activating any of its triggers. In Japan, the BoJ continues to sound like glib ignorance (“Didn’t see the Yen at 150”). And in China, the BoC’s wait-and-see approach to stimulus is starting to sound more like circular avoidance (“The economy is going to do what it was told to do”).

The power of sentiment to codify emotional groupthink increases exponentially with uncertainty. Until now, the pivot faithful have portrayed the ongoing inflation and high yields as nothing but a wild night out that should be forgotten, like a regrettable weekend in Vegas (no serious investor thinks this). Volatility too will pass, they say, like a kidney stone (those are not painless!).

A Fed pivot is key for fans of the MEGA (Make the Economy Great Again) investment strategy, who blindly believe that Wall Street is the tacitly acknowledged fourth​ branch of the federal government and that, as such, the Fed is mandated to come to its aid whenever it feels threatened. But here is the rub, the economy is saying “I don’t need to be made great again because I’m already great“.

As of now, the probability of a pivot has slipped to June 2024 at the earliest (36.8%2). So, is the Fed delaying pivoting to support the economy, because the economy does not need support, or does the economy not need support, because the Fed hasn’t pivoted yet? Chicken, egg; egg, chicken.

Pending the answer to this riddle, the current imbalance between the supply (high risk aversion) and demand (low risk tolerance) for risky assets will keep equity markets under pressure and highly vulnerable to drawdowns from further negative narratives from geopolitics, this week’s macro data releases, corporate earnings, bond yields, or oil prices. For more details on the impact of the conflict in Israel on equity prices, read our blog on the initial market reactions.

Note: green background = bullish, red background = bearish

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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1 If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.

2 First meeting at which the CME’s FedWatch predicts a higher probability of a cut (36.8%) than the probability of no change (33%).

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