LEGO®, the Danish interlocking toy bricks, can be used to construct imaginative designs. The bricks themselves are not overly strong. But when placed together in specific ways, they can create sound structures. A bridge can be built that can hold up to over 1,000 pounds, for example.1 Yet, make a mistake or lose a piece under the couch, and your design becomes unstable and apt to break.
The fragility and strength of LEGO designs, and the bricks themselves, is like the recovery — an elaborate and intricate structure that requires specific actions (i.e., bricks) to be placed in the right order by multiple parties in order to be successful. Together they are stronger than when just by themselves. Miss a step? You’ll have to go back 20 pages to find out where one little piece suddenly ruined a significant amount of hard work. Sound familiar?
The slowing pace of vaccines combined with the rising case rates from the Delta variant has set the recovery back. Once again, we are watching sporting events that feature no fans (the Olympics), mask mandates are returning, and lockdown/capacity restrictions are being enforced in certain regions around the world. All of this will have knock-on effects for confidence and the trajectory of the economy.
Yet, we have witnessed, and continue to see, the other helpful instructions for this recovery build: supportive monetary and fiscal policies aimed at repairing growth and offering stability. These conflicting trends are one of the reasons why investors have begun to express a bullish but worried mentality, leading to a month where global equities notched new all-time highs while volatility spiked and credit spreads widened.
Flows Hit Records
Even with the presence of new and more dangerous COVID-19 variants, markets rallied and investors continued to deploy capital into ETFs at an elevated pace. Global equities registered their sixth consecutive month of gains in July, their longest stretch since 2018. And ETFs took in over $50 billion last month, their ninth consecutive month of more than $50 billion of inflows — a record streak.
The flows in July pushed full-year 2021 figures to $518 billion, a new calendar record in just seven months. With such dazzling flow totals in a short period of time, it begs the question of how high flows could get in 2021 — particularly if ETFs can make it into the four commas club (more than $1 trillion of flows).
While projections are worth the paper they are written on, the below shows a composite approach to ascertaining what may be possible in 2021. Five different projection models were used to forecast potential 2021 flow totals:
A final composite average of these five metrics was tallied to get a full-year 2021 projection of $797 billion — a strong figure and one that would be 60% higher than the $505 billion from 2020. Depending on the trajectory of the market and the vibrancy of the economic and societal recovery, this forecast is well within reason. And if flows do come close to this level, it would mean that there would be more flows into ETFs in one year than in the last nine years combined for mutual funds — a testament to how ETFs are the vehicle of choice for investors today.
ETF Flow Projections
Equities Carrying the Freight
As markets continue to rally, equity ETFs have been the main beneficiary. Following $35 billion of inflows in July, equity ETFs have now taken in $391 billion in 2021 — a record figure for any calendar year, or in fact, any rolling 12-month period prior to 2021 — even though this occurred in just seven months. But the July flows were both 32% above the long-term average and also the weakest in over nine months, underscoring the bullish-but-worried sentiment percolating within markets currently.
With US equity markets leading the rest of the world in terms of performance, the majority of equity assets have been allocated to US equity strategies in July (+$21 billion) and in 2021 (+$242 billion). These strong flows have pushed total assets in US equity-focused ETFs to nearly $4 trillion for the first time.
Outside the US, flows into regional funds slowed, and nearly flipped negative. Yet so far this year, they are the category with the highest organic growth, taking in 33% of their start of year assets. Funds focused on European equities have led within this category, taking in $913 million in July and $14 billion in 2021.
Asset Class Flows
As shown above bond ETFs added $17 billion in July, their 32nd month out of the last 33 with inflows, as investors continue to increase their use of fixed income ETFs. Last month, as they have been all year, flows were fueled by broad Aggregate (+$9 billion) and TIPS (+$3.6 billion) ETFs. The TIPS flows are the second highest flows ever for TIPS in a month and have shown a strong relationship to trends in inflation during the recovery, as shown below. Credit-related exposures had net outflows (-$1.4 billion), given the widening of spreads and uptick in volatility. Yet, out of that combined category, loan flows remained positive (+$136 million) for their tenth consecutive month.
TIPS Flows versus Changes in Inflation
Sector and Factors Tilt Defensive
Sector flows reinforce this bullish but worried, or fragile but sturdy, sentiment. While sector flows were positive for their 10th consecutive month, one-month shy of their record streak, flows were more focused on defensive sectors. Defensives took in $5 billion in July, their second-highest flows ever and a departure from the trend where cyclicals had outpaced defensives for the prior 11 straight months. In fact, given cyclicals had outflows last month (-$7.2 billion), the differential between defensives and cyclicals is the largest ever (+$12 billion to defensives).
Flows into factor ETFs add to this mentality. Funds targeting firms with more stable earnings and quality balance sheets (i.e. the Quality factor) took in $2 billion in July, their second highest ever for a month. Like sectors, the more cyclically oriented Size and Value funds witnessed outflows, a reversal of the year-to-date trend.
The Next Brick to Connect
A silver lining to the rise in cases is that it could potentially lead to more vaccine awareness (e.g., incentive programs, company mandates), and hopefully vaccinations — the most important interlocking piece needed to move past the pandemic.
Looking ahead, constructing portfolios with an overweight towards risk assets may still be rewarded. But it will not be without any volatility, as everything is not awesome. A barbell approach that owns a mix of cyclical US equities, undervalued European stocks, and defensive bonds (e.g. MBS and Treasuries) may result in a structure that can be both flexible and sturdy — focusing on equity markets where vaccination rates are elevated and fundamental foundations are strong. And within credit, to obtain any form of income, exposures should not be overly equity sensitive (e.g. bank loans), as not to add in significant implicit equity risk from the bond side of the portfolio.
1 “‘Lego Masters’: Oregon team tackles a bridge-building challenge, tries for the ‘Golden Brick’”, OregonLive March 2020: https://www.youtube.com/watch?v=G9WT6TB15yE.
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