Bearish positioning increases the risk of a market rebound

In the latest instalment of Simply put, we examine investors’ increasingly pessimistic portfolio positioning and consider whether this will present challenges in the event of a market rebound.  

Fear over fundamentals

Is the global economy on the verge of a recession? This is what the recent evolution of investor positioning seems to suggest. Wherever you look, investor pessimism is there: through portfolio exposure, confidence surveys, intra-asset-class correlation and also in the correlations between equity styles. We review these signals to determine our view of the risk that current market positioning, or sentiment, poses to markets.

Sentiment is one of the major forces that drives the valuation of financial assets. John Maynard Keynes’s "animal spirits" – an established economic idiom – allegorically express this psychological aspect of financial markets: while fundamentals drive asset prices over the long term, in the short term exaggerations and psychological biases are legion – and today is no exception to this rule. Figure 1 shows various signs of the ambient pessimism that has formed since the beginning of the year.

FIG 1. Market sentiment indicators, through previous cycles to today

Source: Bloomberg, LOIM

Looking at these data, we make the following observations:

• Investor sentiment surveys are at historic lows. This collapse at the beginning of the year coincided with the mass exit from growth stocks by retail investors. Since then, pessimism has remained marked and is comparable to financial markets’ darkest episodes.
• Hedge funds' equity exposure (as measured by their beta to this asset class) has drastically declined since the beginning of the year. It is currently in the third quartile – which indicates very low levels already.
• While the negative correlation between bonds and equities has weakened considerably, amid the recent joint decline of these two asset classes, intra-asset-class correlations have increased significantly. Since the beginning of the war in Ukraine, the intra-asset-class correlation – among bonds, currencies and commodities, but excluding equities – has risen from 57% to 71%¹. When this correlation rapidly rises to such levels, it reflects the fact that markets are trading on a common factor, which is usually risk aversion. Moreover, risk aversion is usually the result of a large economic shock – most often a recession.
• Equities have not been immune to this rise in intra-asset-class correlation. What is striking here is that while growth and value stocks saw their correlation collapse over the period from 2020-2021, this anomaly is now in the process of being eliminated. In May 2020, this correlation reached 96%, well above its historical average of around 90%. Yet, by January 2021, this same correlation had collapsed to just 11%. These figures are based on the MSCI World indices and are therefore not specific to regions, but European and US indices exhibit similar trends. In our view, the market is increasingly treating these two styles in a similar fashion, highlighting the fundamental undercurrent behind the rotation since the beginning of the year. At this point, the bearish rotation is increasingly showing signs of being an actual bear market complemented by a rotation – another sign of the prevailing pessimism across most markets.

The problem with sentiment is that it can naturally be interpreted in two ways: either as a trend-following or as a contrarian signal. In terms of the former, negativity is an invitation to be more cautious with portfolio allocations – favouring cash and diversification sources, in particular. For the latter, there is an expectation of sharp market rebounds, which can occur amid very little liquidity and could test the nerves of many investors.

As described previously in Simply put, there are few economic statistics that consistently align with this extreme investor negativity at present. However, like others, we expect macro conditions to deteriorate in the future. A rebound would certainly shake this conviction and could prompt defensive investors to chase an apparent market recovery. In our view, investors should remain as systematic and process-driven as possible to avoid being caught between a rock and a hard place should a recovery happen. Whether investors choose to buy into such a recovery or not depends on their medium-term outlook, because if a recession takes place (as many fear), any recovery would likely be a bear market rally.

Sources 

[1] Average intra-asset class correlation across a set of representative derivatives of each asset class. 26-weeks trailing correlations.

Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

The main macro news this week was the US inflation report, which provided a pivot for markets. The headline data was not bad: US inflation rose 0.35% in April, in month-over-month terms, 10 bps higher than expected. Core inflation was even higher, climbing as much as 0.6% over the month, ahead of expectations of a 0.4% rise. Energy had more of a negative contribution to inflation last month, despite the US’s lower exposure to the price of gas and the fact that a rising US Dollar is cushioning some of the progression of commodity prices. 

Markets pivoted on the back of this report for one key reason: for the first time since 2021, goods inflation progressed less than service inflation. In a nutshell, this number marked a retreat for goods inflation for the first time since the rise in the Covid disruptions – good news indeed. The bad news was that service inflation continued to rise, reflecting the strength of the housing market. The cost of shelter is running strong: in year-over-year terms, the cost of shelter has risen 5.1%. The only known way to moderate this surge is central bank action. Markets acknowledged that by starting to anticipate a recession, which could be triggered by the Federal Reserve (Fed) tightening rates further. 

In Europe, the newsflow was limited.

Meanwhile, in China inflation remains very low (+2.1% in y-o-y terms for April), while PPI showed a continued moderation (+8%, vs +8.3% last month). In addition, Chinese exports continued to grow at a solid pace: +1.9% in y-o-y CNY terms, highlighting the ongoing strength of world demand.

Factoring in these new data points, our nowcasting indicators currently point to:

• Worldwide growth remaining solid. The US and the Eurozone still show solid numbers, while China remains set on a deteriorating path.
• Inflation surprises should remain positive but our signals show a recent decline. A normalisation of inflation requires our indicator to go below the 50% line: we are not there yet.
• Monetary policy is set to remain on the hawkish side, mirroring the strength of activity. The Fed has once more confirmed its hawkish stance; the European Central Bank should be next.

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)
   
World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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