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February Flash Flows: Rates Try to Drink Stocks’ Milkshake

  • ETFs are off to their best start ever for a year, taking in over $150 billion in the first two months
  • Equity ETFs, led by cyclical exposures at the sector and style level, fueled the record setting flows
  • While investors have focused on rate sensitive equities, they have also focused on growth sensitive bonds with another $1 billion into bank loans 
Head of SPDR Americas Research

The movie There Will be Blood is an epic tale of the nefarious rise of an American oil tycoon Daniel Plainview. It is most often memorialized by the five-minute scene late in the movie when Daniel reveals to Eli Sunday that the land Eli owns is worth nothing, as Daniel owns the drainage rights and has already sucked it dry. In illustrating his dastardly act to a befuddled Eli, Daniel proclaims, “If you have a milkshake and I have a milkshake, and if my straw reaches across the room and starts to drink your milkshake, then I drink your milkshake!”1

Interest rates said the same thing to stocks and the traditional 60/40 asset allocation mix last month. With a 22-basis point rise in the US 10-year yield over the last two weeks of the month, global equity markets fell by almost 4% in those 10 days. And this decline in equities was matched by a decline in bonds, given the natural relationship of when yields rise bond prices fall.

This increase in rates is, therefore, having an impact on the standard 60/40 allocation, as bond/stock correlations have increased. As of right now, the rolling 60-day correlation between the S&P 500 Index and the Bloomberg Barclays US Aggregate Bond Index is -9% – noticeably higher than the long-term median of -25%.2 Growth stocks, which can be considered long duration equities given the far-off nature of cash flows and the impact the discount rate has on lofty valuations, are even more correlated to bonds right now (2% correlation versus a -23% median).But not all areas of the stock market have become more correlated with bonds alongside this spike in rates. Value stocks have noticeably decoupled from the other two equity barometers’ trend. Right now, with value stocks up 13% this year – including a 2.6% gain in the last two weeks of February – value has a -48% correlation to bonds, compared to a -27% long-term median.4 And there is rationale for this type of move.

Value, after all, is a much shorter duration equity style that has historically had a more positive relationship to interest rate movements than growth stocks – evidenced by its over 55% correlation to rates compared to just 27% and 34% for growth stocks and the broader market, respectively.5 And right now, as this correlation would indicate, the rising inflation and growth expectations have pushed interest rates higher – leading to a rotation out of growth and into value.

Even with this increase in performance, value’s relative valuations to the S&P 500 are in the bottom decile – compared to top decile for growth.6 Additionally, expected 2021 earnings-per-share growth (25%) is above that of growth (20%) and the market (24%), indicating a cheaper source of growth and another catalyst for the rotation to continue.7

This stock/bond correlation for value is likely to mean revert in time. However, for right now, it underscores the regime shift present in the markets today. And as the recovery takes shape, cyclical/value equities may offer ballast from rising rates impacting the equity side portfolio. Focusing on rate-sensitive stocks, therefore, may be one way to mitigate interest rates being able to drink the standard 60/40’s milkshake in 2021, and potentially prevent it from being caught on the wrong end of a bowling pin.

Hot start for stock funds with a cyclical focus

US-listed ETFs are off to their best start to a year ever, totaling $152 billion through the first two months of 2021. This outpaces the prior best start by over 74% (+$88 billion in 2017). In fact, only the flows from November and December 2020, when the dual headwinds of vaccine timeline and election uncertainty were initially removed, provided a better two-month period. Combining the last two months of 2020 and the first two months of 2021 leads to a total of $309 billion of flows in the past four months. If those four months were a full calendar year, it would rank fifth all-time – a strong testament to the bullish positioning from investors as of late.

The record-setting monthly flows so far run counter to the typical start-of-year trends. Historically, on average over the past ten years, January has been the eighth-best month in terms of flows, with February the tenth. So, while the flows in February broke absolute records, they also shattered the monthly February record, as flows were six times greater than the monthly February average (+$16 billion). Furthermore, equity ETF flows were a staggering 13.5 times greater than their February average (+$6.3 billion) last month.

The beneath-the-surface flows continue to paint a cyclically oriented bullish positioning picture, as well as one where investors are seeking out specific pockets of opportunity and not just buying broad beta to participate in the recovery rally. For example, flows into sectors, in the aggregate, were $15.6 billion. However, that entire total was led by cyclical sectors: Financials ($4.9 billion), Energy ($3.2 billion), Real Estate ($2.5 billion), and Consumer Discretionary ($1.7 billion) had the most flows, but all cyclical sectors had flows over $1 billion on the month.

US Small-cap and Value style ETFs also benefited from this continued cyclical recovery powering the record flows to start the year. Small caps took in $7 billion on the month, their third-most monthly flow figures ever. While Value ETFs’ inflows of $5 billion are only the fifth-most ever for a month, the flows in February mark the fourth consecutive month of over $5 billion of flows – a record streak.

Cyclical sectors outpaced defensives by $15 billion last month, with the rolling three-month total differential now nearly $40 billion – a record 14 times greater than the long-term average differential. Based on these flow patterns, investors have been favoring rate-sensitive stocks to mitigate the impact on broader portfolios from this new higher rate and reflationary regime shift. And even though performance has rallied recently on both Financials and Energy, their valuations remain attractive and sit in the bottom decile relative to the broader market.8 Financials have the added potential benefit of stronger earnings sentiment as well, as we show in our sector scorecard.

Growth sensitive bonds sought

Fixed Income positioning was on the lighter side in February, with the $11 billion of inflows just below the three-year monthly average. The dour flows coincided with US 10-year yield breaking above its pre-pandemic level and the broader Bloomberg Barclays US Aggregate Bond Index (Agg) falling by 1.4%. That is the Agg’s worst monthly loss since November 2016, a time period when the market was also gripped with reflation euphoria. Back then, it was based upon the potential for tax cuts, as opposed to the numerous stimulus bills and accommodative monetary policies reigniting the reflation fires today.

The bond sector where flows were not light, however, was Bank Loans. Flows once again were over $1 billion, pushing 2021’s two-month total to over $2.7 billion – more than the past five years combined. Loans are in favor right now as a result of their relative high yield (3.7%),9 likely ability to continue benefiting from the loose monetary and fiscal policies supporting risk assets amid this reflation rally, and the potential to dampen the impact from a rise in rates due to their floating rate structure.

The milkshake defense

Overall, the flows underscore the bullish optimism as the broader global economy seeks to recover. Higher interest rates, as Federal Reserve Chairman Powell mentioned, are a sign of confidence in the recovery. In addition to focusing on rate- sensitive stocks, investors’ focus on growth-sensitive bonds may also be another way to mitigate the impact on portfolios from this new higher rate and reflationary regime shift.

So far, it appears investors are positioning portfolios along those lines by distinctly allocating to specific rate-sensitive stock markets (e.g., Financials, Small-Caps, Value) and some growth-sensitive bond sectors (e.g., Loans, EM Debt).