Technical strength was forming at the end of July, as the MSCI ACWI Index approached 100-day moving average. There was strong breadth beneath the surface as well. Yet, sentiment remained subdued as equity flows (+$14 billion) were 64% below their monthly average and risk-on sectors had outflows — a sign that investors viewed the strong July returns as a potential outlier.
Every morning during baseball season, I begin my day by reading Fact versus Flukes, an in-depth analytical article about players’ performances. Published by Baseball HQ, the authors use a data driven approach to determine if a player’s recent string of strong stats is a result of skill or luck.
The article tries to answer these questions: Is the player, in fact, a budding star? Or are the past month’s box scores a fluke, with a reversion to the mean likely down the road? It’s a fun read, especially when it confirms your thoughts about a player on your fantasy team that is having a strong year.1
In July, global equities registered a near 7% return2 and risk-on high yield bonds posted a similar 6% return in July,3 after spreads tightened by 100 basis points, reminding me of my daily fact or fluke exercise. Are July’s stats facts that support an uptrend for the market or are they just a fluke during a year of sour returns?
Based on buying behavior, investors might feel they could be more “fluke-ish” than fact.
Investor sentiment was not overly enthused by the markets' returns; both the magnitude and breadth of flows were well below historical paces. Equity funds took in just $14 billion in July, 64% below than their typical monthly average. Less than half of all equity ETFs (49%) had inflows, compared to a historical participation rate of 62%.
Bond funds, however, had $26 billion of inflows in July — their seventh-most ever for a month. The strong bond flows and weak equity flows have constrained the rolling three-month differential between the two major asset classes well below the historical median, as shown below. This risk-off high level asset class positioning doesn’t equate to unbridled investor enthusiasm.
Rolling Three-month Equity Minus Bond ETF Flows
The beneath-the-surface trends also do not paint a picture of significant risk-taking amid the rally in risk assets. Sector funds, where investors can express an active risk directional market view, had outflows of $5 billion. This is their third month in a row with outflows, one month shy of breaking a record.
The outflows in sectors have been driven by cyclical market exposures, as cyclicals had $7 billion of outflows in July. This is their sixth month in a row with outflows, a record.
Defensive sectors took in $1.8 billion in July, led by Health Care (+$1.6 billion) and Utilities (+$301 million) — two sectors that have historically had stronger market returns than other sectors during slowdowns and recessions. Defensive sectors have now had inflows for nine consecutive months, a record that has witnessed $25 billion amassed.
The beneath the surface geographic picture depicts an equally sluggish trend. As shown below, four out of the six geographic segments had outflows in July.
Outflows from single-country funds mirror the trend reflected within sectors, as these ETFs are another way to tactically express directional risk views. Single-country funds had $1.3 billion of outflows in July, with 64% of the countries with activity experiencing outflows. At a more granular fund specific level, only 34% of single-country funds themselves had inflows — compared to a historical 54% rate.
Bond funds posted their seventh-best month of inflows (+$26 billion), buoyed by contradicting actions — roughly $5 billion of inflows into equity sensitive high yield exposures and $12 billion into defensive government bond ETFs. For the latter, most of these inflows were into long-duration exposures, as the weak growth figures combined with tighter monetary policy flattened the curve by 30 basis points.
The $4.7 billion of inflows into high yield were backed by strong underlying performance, with spreads tightening by 100 basis points in July. For high yield, this was a significant reversal from their year-to-date trend, as high yield had a calendar year record-setting amount of outflows (-$16 billion) heading into July. However, the -$11.1 billion would still be a calendar year record.
Fixed Income Sector Flows
While technical breadth has been supportive, there is more to the story as it is coming from some less than stellar sources. For instance, from a quantitative factor perspective, here’s what worked well last month:
Stocks with those attributes, alongside weak fundamentals and sluggish economic data, are unlikely to provide the foundation for a strong rally. As a result, unfortunately, the 7% return in July is more of a fluke than fact.
Not to mention that these strong returns came after supremely weak returns in June (down 9%) — so July was a bit of a give back. They also occurred on light summer volumes and met with low levels of buying behavior evidenced by flows and positioning metrics.8
Overall, our outlook remains intact: expect a confluence of converging complex risks (tightening monetary policy, slowing growth, weak earnings sentiment, and elevated geopolitical risk) to lead to elevated cross asset volatility. Consider emphasizing high quality value within equities and limiting duration in bonds in a complex market with choppy returns.
1 Like the recent report on Tarik Skubal.
2 Bloomberg Finance, L.P., as of July 31, 2022 based on the return of the MSCI ACWI Index.
3 Bloomberg Finance, L.P., as of July 31, 2022 based on the return of the ICE BofA US High Yield Index.
4 Bloomberg Finance, L.P., as of July 31, 2022 based on the Nomura long high volatility factor basket.
5 Bloomberg Finance, L.P., as of July 31, 2022 based on the Nomura 1-month reversal long factor basket.
6 Bloomberg Finance, L.P., as of July 31, 2022 based on the Nomura high short interest long factor basket.
7 Bloomberg Finance, L.P., as of July 31, 2022 based on the unprofitable versus profitable stocks within the Russell 3000 Index based on trailing 12-month earnings-per-share.
8 Bloomberg Finance, L.P., as of July 31, 2022 based on the NYSE total volumes and percentile rankings of AAII Survey Stock Allocations sitting in the 19th percentile over the last three years.
ICE BofA US High Yield Index
Tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
MSCI ACWI Index
A market-capitalization-weighted stock market index that measures the stock performance of the companies in developed and emerging markets.
S&P 500® Index
A market-capitalization-weighted stock market index that measures the stock performance of the 500 largest publicly traded companies in the United States.
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