ROOF Highlights — October 25, 2021

Qontigo ROOF™ Score Highlights: Week of October 25, 2021

Potential triggers for sentiment this week1 :

  • US: Q3 earnings for Apple, Facebook, Microsoft, Alphabet and Amazon. Q3 GDP, durable goods orders, and personal income releases.
  • Europe: ECB interest rate decision, Eurozone inflation, business survey, and GDP updates, as well as UK budget release.
  • APAC: Japan retail sales, industrial production and BoJ interest rate decision; Chinese PMI.

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:

  • The divergence in investor sentiment between developed and emerging markets widened further last week. Sentiment in the US and developed Europe is now firmly in the bearish zone, with those of the developed world and Japanese investors just managing to remain at the bottom of the neutral zone, for now.
  • In contrast, investor sentiment in Asia ex-Japan and global emerging markets continued its recent rise and is now well into the bullish zone. Sentiment among Chinese investors peaked last week ahead of the Evergrande coupon payment date, but remained at the top of the neutral zone. News of that payment having been made over last weekend may help sentiment in China rise this week, supporting further market gains.
  • The source of developed-markets investors’ fear is macroeconomic in nature, and when it comes to getting uncomfortable about the economy, it’s enough to know that we don’t know enough. Both the Fed and the IMF have already conceded they were becoming increasingly concerned about inflation without raising the alarm bell, yet. The BoJ and ECB rate decisions later this week will either heighten or sooth these concerns for investors.
  • This is supposed to be comfort week for developed-markets investors, with Q3 results from four of the FAANGs plus Microsoft. The trend so far with the pandemic beneficiaries, has been to forecast first, then embellish. The big risk for markets now, given the current bearish sentiment, is for a sour taste in these reports. The combination of a tepid central bank support and disappointing FAANG earnings could be disastrous for markets in the short term.

US investor sentiment:

US investor sentiment (green line) remained flatlined in the bearish zone (below -0.5) last week. The rise in market returns was therefore driven by a continued preference for risk-averse sectors rather than by changing investor risk appetite. This week’s Big Tech earnings reports could be a potent trigger for sentiment if they contain any negative surprises. Conversely, since positive results are expected, good news is likely to get a lukewarm response from bearish investors who remain focused on the potential negative impact of inflation on the macroeconomic front.

The previous week’s gap between risk aversion (red line) and risk tolerance (green line) continued to widen last week as investors increased their penchant for risk-averse sectors and reduced their exposure to risk-tolerant ones. At this level, the imbalance between the supply (risk aversion) and demand (risk tolerance) for risk is large enough to cause a downside over-reaction should a negative event trigger sentiment into action. Big Tech results and the ECB rate decision loom large on markets this week and both could set off the negative sentiment.

European investor sentiment:

European investor sentiment dropped out of the neutral zone into the bearish zone last week. Unlike the US, the rise in markets here seems to have been on the back of an increase in risk appetite. The sector allocation signal (red dotted line), which excludes the two risk metrics in our methodology, points to increased demand for risk-tolerant sectors last week ahead of the ECB rate decision this week. So, even though the ROOF ratio (green line) is now in bearish territory, this decline in sentiment seems to reflect a de-risking of the portfolios rather than a rotation into risk-averse sectors (since the red dotted line rose). This means that European investors have put their faith in the ECB and a lot will depend on this Thursday’s rate announcement and accompanying press conference.

The gap between risk aversion (red line) and risk tolerance (green line) is now back at YTD highs. The current large imbalance between the supply and demand for risk is reminiscent of the spreads seen in March, June and August of this year. Each time then, the ECB stepped in to calm markets and assure investors of their continued focus on stimulating the economy. Will this time be different?  Failure to unequivocally support the economic recovery will act as a trigger for the negative sentiment and lead to an over-reaction on the downside. Conversely, assurances of ongoing support could lead to a reversal of the supply-demand dynamics over the next few weeks, as was the case in the three previous instances this year.

Global developed markets investors sentiment:

Global developed-markets investor sentiment continued to slide lower towards the bearish zone last week, encouraged by sentiment in the US and developed Europe. Stocks, on the other hand, rose sharply last week but failed to reach new YTD highs. This week will be critical for sentiment and markets with influential earnings and central bank news due. Given the weak signs of support from the Fed and IMF earlier in the month, it is hard to see how the ECB and the BoJ, looking at the same inflation data, can diverge from their peers and provide enough stimulus to reverse the course of sentiment. Even if they do support investors’ spirits, markets may have already overstepped their level of risk tolerance and may need to correct in the short term in order to restore the balance with sentiment.

Risk tolerance (green line) and risk aversion (red line) continued to diverge last week and have reached a big enough negative balance to cause a market correction in the event of a negative news. Given the weak risk appetite, any hesitancy on the part of the ECB, or weaker-than expected earnings from the US Big Tech, could trigger a downside reaction from investors like the ones experienced in March or September of this year.

Asia ex-Japan markets investor sentiment:

Markets and sentiment continued their parallel upward move this month in Asia ex-Japan. Investors seem to focus more on the region’s relative low valuations than on macroeconomic fundamentals or short-term default risk issues. The YTD underperformance of Asia ex-Japan markets vis-à-vis the US and Europe means that investors do not think the current economic rebound will result in higher earnings for regional companies. Perhaps, then, the recent rise in sentiment only points to a potential relief rally and not a change in the YTD downtrend?

Risk tolerance (green line) surged last week while risk aversion (red line) dropped further, indicating an increase in investors’ risk appetite. We note that the positive imbalance between the supply and demand for risk in the region has been higher twice before, and that both times the rally it fostered fizzled rather quickly. The sustainability of any rally may depend more on what happens in the US and Europe this week than on what happens in the region. On the bright side, with sentiment this positive, any downside seems limited.

Global emerging markets investor sentiment:

Emerging markets and sentiment seem to be back in sync this month, both continuing to rise strongly last week. Like markets in Asia ex-Japan, global emerging markets have low valuations relative to their western developed peers and have been strong under-performers all year. The improving sentiment limits the downside risk and could be a setup for a strong rally if positive news comes out this week.

Risk aversion (red line) declined further last week while risk tolerance (green line) continued to rise, indicative of an increasing risk appetite. The positive imbalance between them is still recent and may not yet be strong enough to be sustainable. Some of this improving risk appetite may be related to the upcoming climate conference and projected promises of financing for sustainability projects in the emerging world by developed nations. Any disappointment on that front could easily reverse the recent gains in risk appetite. On the other hand, concrete investment targets and detailed projects could leverage the improved sentiment into a strong relief rally.