The historical relationships between investor sentiment, risk and uncertainty have broken down and while this doesn't necessarily mean things will end badly for investors, something has to give.
Citi credit products strategist Matt King is astounded that markets held up as well as they did in 2016 despite political upheaval. In his Global Credit Outlook 2017, Mr. King noted that the highest risk segments of global markets – including collateralized loan obligations (CLOs), high yield corporate debt and commodities – outperformed despite two major political shocks, Brexit and the outcome of the U.S. election.
Political tensions have only intensified in recent weeks and yet the primary market-based indicators of investor sentiment indicate complacency rather than concern.
The first chart below compares a prominent investor sentiment survey with the CBOE volatility (VIX) index. The latter attempts to predict short-term market performance using futures prices, with a rising VIX indicating investor fear.
The American Association of Individual Investors (AAII) surveys investors each week and calculates the percentage of bullish and bearish investors. In the chart, the salmon-coloured line represents the number of bearish investors minus the number of bullish investors – a rising line indicates rising bearishness.
The results cover a short, 12-month period and the correlation is far from perfect, but in general the degree of investor bearishness follows the VIX index. Beginning Jan. 5, there is a notable increase in bearish sentiment in the AAII surveys, but the VIX has fallen to 12-month lows. More investors are worried about markets, but this has yet to be reflected in futures prices.
The second chart below is a recreating of one presented by Mr. King in his recent report. It uses an economic policy uncertainty index developed by finance and economics professors at the University of Chicago and Stanford University (more data are available at policyuncertainty.com). The index combines economic forecaster disagreements, proposed tax changes and media coverage to measure policy uncertainty in markets.
The salmon-coloured line in this chart is a Merrill Lynch index that tracks the yield of triple-A-rated corporate bonds relative to government bonds. A falling line indicates rising complacency – a lower margin of safety (in terms of extra yield) being demanded by investors to accept the added risk of corporate bonds.
Over the long term, the pattern on the chart is what we'd expect. Lower amounts of policy uncertainty are associated with lower corporate bond yields. As with the first chart, however, a divergence has appeared in recent results. The policy uncertainty index, thanks to President Trump, has climbed sharply but actual corporate bond prices don't reflect this – yield spreads relative to government bonds have continued to decline.
I expect the anomalies in the charts to be resolved in the coming weeks and for the lines to resume moving roughly in tandem. Ideally, this will take the form of the AAII investor surveys turning more positive (in this case reflected in a falling line), and for policy uncertainty to decline. Both would be supportive for higher market prices.