The US CPI numbers were a psychological turning point for the market. There have been undershoots of inflation before but this one was particularly significant given the change in tone from the Fed. The FOMC wanted to decelerate the pace of policy tightening and this gave them the justification. The 10Y US Treasury yield has rallied 40bp since then, despite indications from the Fed that terminal rates could well be higher than the 5% priced by the market.1
A lower interest rate profile benefits other asset classes. Coupled with the feeling that China may be peeling back at least some layers of their strict Covid lockdown laws, it helped support equities and other risk assets, with the S&P 500 index up almost 7.5% since the close on 9 November. While there is some genuine optimism that this could mark a turning point for the markets, a part of the move was driven by position squaring. So the bolt of good news pushed against a market that was positioned for continually rising inflation, higher interest rates and weaker growth and earnings.
Inflation is seen as being close to or potentially past its peak in most of the G10 but there remain plenty of questions on how far rates need to rise in order to bring inflation lower. So there may well be more market volatility to feed through. That said, for now, many in the market are comfortable that the October CPI numbers do signal a turn of sorts. From that respect, the flows that have been recorded in the market since 10 November should be representative of where market participants will be looking to invest in the post peak inflation world.
EMEA ETF flows from 10 Nov 2022 to 22 Nov 2022 for selected categories (in $m)
Source: Bloomberg Finance L.P., State Street Global Advisors as of 22 November 2022. Flows are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.
Equity ETF investors have embraced the rally and flows have accelerated also helped by the better than expected US PPI numbers. The segment which has enjoyed strongest net inflows was US large caps, taking in $1.2bn of net new assets since 10 November. If inflation continues to fall and does so at a rapid pace, US equities will be well positioned to enjoy both strong performance and inflows given their long duration, defensive profile and the valuations which are no longer stretched.
Interestingly, investors continued to buy in into Japan equities which have gathered $166mn since 10 November. Despite some depreciation of the US dollar, the Japanese yen remains very weak, thus supporting Japanese companies which derive nearly 50%(2) of their revenue from outside Japan.
Emerging market (EM) equities also saw some decent interest, gathering over $400m. EM performance was further boosted by news on the potential easing of covid related restrictions in China. However, this may prove transient given the rising number of covid cases has meant the re-emergence of lockdowns. Further US dollar weakening combined with a gradual move towards the end of zero covid policy and the loosening of scrutiny over tech companies in China would certainly serve as an inflection point for investors to buy into EM equities.
We observed strong performance from European equities too but ETF investors have been more cautious given the upcoming winter season and persisting geopolitical uncertainty. As such broad European exposures endured $1.1bn of net outflows while European sectors lost $427mn and that stands in contrast with most other equity regions.
For fixed income ETFs the highest inflows ($1.4bn) have been into euro denominated investment-grade corporate debt. One reason for this would certainly have been related to the idea that with inflation topping out, the ECB may not be forced to hike rates too high. The 1 year forward of the 1-month EUR rate has declined 15bp from the levels seen prior to the US CPI. Coupled with the decline in energy prices, this should help to reduce the risks of a severe recession, which had been a significant risk factor hanging over credit markets. While investment grade exposures benefitted, there was little support for Euro government bonds which recorded net outflows. This could have been driven by switches out of government into investment-grade bonds as, with spreads at the time that were over 200bp, investors are well compensated for the risks of a deterioration in credit quality as a result of weaker growth.
Strong flows of $422m were also seen into US government bonds. However, the trend of flows into treasuries has not been driven exclusively by the turn in inflation. It has been the top gathering strategy for fixed income for 2022 with over $15bn of inflows. The inflows are potentially more a sign that investors are comfortable bearing the risks of a further sell-off, given the now higher yields on offer.
At the other end of the spectrum there has been net selling of emerging market debt. At first glance this seems at odds with the more risk-on tone to markets, but much has been driven by outflows from China bonds. This makes more sense given the PBoC has been one of the few central banks in easing mode. A slightly more relaxed approach to Covid, resulting in stronger growth, coupled with measures to help the real estate sector, probably means less support from the central bank will be required.
1 State Street Global Advisors, Bloomberg Finance L.P as of 22 November 2022. Flow data for period between 10 November 2022 to 22 November 2022.
2 Source: FactSet, State Street Global Advisors as of 30 September 2022. Revenue weighted by market cap of MSCI Japan constituents.
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