Potential triggers for sentiment-driven market moves this week1:
- US: PCE price index, personal income and spending data, durable goods orders, and (final)
- Europe: CPI data for Germany, France, Italy, Spain, and the Eurozone.
- APAC: Minutes of the BoJ meeting, industrial production, and retail sales in Japan.
- Global: A US government shutdown and continuation of the US auto workers’ strike could dent economic forecast for the US.
Insights from last week’s changes in investor sentiment:
Investor sentiment was mostly unchanged last week, except in the US and Global Developed markets where it worsened, reaching bearish levels. In China and Emerging markets, sentiment improved further, turning bullish in the former, thanks to better manufacturing PMI data for August and talks of a third stimulus package by the authorities. The global average ROOF ratio remains anchored around zero (0.08), indicating a lack of conviction in either direction on the part of investors. This indecisiveness stems from two unanswered questions: When will inflation be defeated? And at what cost to the economy? Investors are also slowly beginning to accept that monetary policy will remain restrictive for longer than previously thought.
Both the Fed and the ECB have been pulling hard on the strings of the economic impulse for some time now, but to no avail. Consensus remains for a no-landing in the US and a soft-landing in Europe. Large-cap equities meanwhile, are up 18% and 12.5% respectively – unfriending central bankers is hard for investors in these markets.
Declining volatility levels have been a big driver of market performance this year. In the US, predicted volatility was 22% at the start of the year, versus 12% now. And in Europe, volatility started at 17% and has fallen to 11% now. Our experience has been that a prolonged period of low or declining volatility encourages speculative behavior, which, if volatility suddenly rises (e.g., because of an unexpected US government shutdown), can cause a sharp market correction. Some investors have clearly become addicted to AI, much like some were addicted to Bitcoin in 2021 – remember how that ended?
Higher volatility would not be good news for those who bought stocks solely because they expected some other investor to buy it back from them later at a higher price. Low volatility benefits the few. Only strong fundamentals benefit the many.
If we survive/postpone/avoid a US government shutdown over the weekend and volatility remains low, macro news will slowly give way to company-specific news, with the start of the Q3 2023 earnings reporting season in two weeks. Expectations are for a YoY earnings decline of just -0.2% for US large caps, which would make it the fourth straight quarter of earnings decline according to Factset but represent the smallest decline and a possible bottoming out of the earnings cycle.
Macro uncertainty – higher rates for longer, rising energy prices, ongoing political shenanigans – will continue to weigh on sentiment in the short term. But low volatility will keep speculative activity alive and the higher dispersion from company-specific news taking over the front page during the earnings reporting season will allow stock-pickers to apply their trade, and for the skillful ones to be rewarded for it.
If a shutdown is avoided, then expect sentiment and markets to recover. A shutdown, given the bearish sentiment among US investors (ROOF ratio is at -0.51), would lead to an overreaction on the downside, as volatility rises and squeezes a lot of the recent speculative activity out of the market.
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.