Threat of war in Ukraine pushes markets closer to ‘peak pessimism’

Open this photo in gallery:

The threat of a European war has joined an extensive list of concerns weighing on investors this year, raising the question of whether stock market sentiment is approaching a low point.

From surging inflation and the prospect of rising interest rates, to slowing earnings momentum and a downturn for technology stocks, investors have had plenty of reasons in 2022 to take a cautious approach.

Reports that Russia has authorized the use of military force in parts of Ukraine adds a significant geopolitical risk to the mix.

Analysts’ forecast returns and recommendations for all stocks in the S&P/TSX Composite Index

“I wouldn’t necessarily say ‘peak pessimism,’ because that’s almost impossible to quantify. But I would say that we are well along the way to getting there,” David Kletz, portfolio manager at Forstrong Global Asset Management, said in an interview.

Financial markets are certainly reflecting a sense of unease.

The S&P 500 is down more than 10 per cent from its intraday high on Jan. 4. Gold, considered a haven investment, has risen more than US$100 an ounce in February, rising above US$1,900 on Tuesday.

The CBOE Volatility Index, a measure of expected S&P 500 volatility, briefly rose above 30, up from about 17 at the start of the year.

The outlook for corporate profits, a key driver during much of the stock market rebound over the past two years, has dimmed significantly.

According to estimates from Refinitiv, S&P 500 profits in the first quarter will be 6.7 per cent higher than the first quarter of 2021 – and just 2 per cent higher after excluding unusual growth in energy profits.

That’s down from an estimated 32-per-cent profit growth in the fourth quarter (financial results are still rolling in), and the deceleration comes as central banks in Canada and the United States prepare to raise their key interest rates to head off a spike in inflation.

One popular sentiment reading suggests that small investors are losing enthusiasm.

The most recent weekly investor survey from the American Association of Individual Investors (AAII), for the week ended Feb. 16, showed that just 19.2 per cent of respondents felt bullish about the stock market’s direction over the next six months.

That is the lowest reading since 2016 and nearly 38 percentage points below the one-year high last April.

“I think there are a few things affecting individual investors’ short-term outlook for stocks. At the top of the list is the high level of inflation along with the prospect of several interest rate hikes occurring this year,” Charles Rotblut, editor of the AAII Journal, said in an e-mail.

There are signs that more sophisticated investors are also getting antsy.

Jack Ablin, chief investment officer at Cresset Capital Management, a U.S. private wealth manager, believes that a technical indicator based on rising borrowing costs is now signalling trouble for the stock market.

“The signal is now risk-off, something we haven’t seen since the height of the pandemic in 2020,” Mr. Ablin said in a note.

For some investors, though, the deteriorating sentiment toward stocks can be good news if it means that expectations are low, since there could be room for a rebound if the news improves.

Brian Belski, chief investment strategist at BMO Capital Markets, said that geopolitical events tend to shock markets initially.

“But then stocks typically rally pretty sharply after the actual event,” Mr. Belski said in an interview, though he cautioned that the situation in Ukraine is hardly clear right now.

Mr. Kletz added that the biggest concern hanging over sentiment is whether the U.S. Federal Reserve will derail the economic recovery with a succession of rate hikes starting as soon as next month.

However, this is also where he sees room for improving sentiment, as fears over surging inflation subside. Year-over-year inflation numbers will soon begin to look less alarming as the “base effect” no longer factors in unusually low year-earlier figures, and supply chain challenges should be solved as the pandemic recedes, exerting less pressure on the Fed.

“We think we are probably close to peak inflation,” Mr. Kletz said.

That doesn’t necessarily mean that market sentiment has hit rock bottom. But a lot of bad news has already been priced in.

Be smart with your money. Get the latest investing insights delivered right to your inbox three times a week, with the Globe Investor newsletter. Sign up today.