In the seminal 1966 surfing documentary, The Endless Summer, Bruce Brown follows two young surfers around the world in search of the perfect wave. In 2022, investors are likely to catch anything-but-perfect waves during an endless summer of volatility.
Traditional stocks and bonds are already off to their worst-ever start to a year, meaning the standard 60/40 portfolio, down -16%, is as well.1 For this asset allocation model, its returns for the first six months of 2022 rank sixth all-time based on rolling six-month returns dating back to 1977.2 Only periods during the Great Financial Crisis rank worse.
Continued rate hikes, inflation, geopolitical conflict, and waning growth — the catalysts creating our current choppy conditions — are all reasons for this likely endless summer of volatility. Partisan conflict, due to emerging US mid-term election headlines, could knock markets off course even further.
Given this backdrop and poor return environment, flow trends indicate a lack of investor conviction to start the summer.
Buying Behavior Weakened
The $37 billion of inflows sits 30% below the recent 36-month average. Combined with weak flows in May, the second quarter flows totaled just $91 billion.
This is the lowest quarterly figure since the onset of the pandemic (Q1 2020), 53% below Q4 2021 and 30% below the five-year quarterly average figures. This made the first half flows frail as well, totaling just $287 billion — the lowest figure since the first half 2020 and a 40% decline from the first half of 2021.
Quarterly Fund Flows
The $34 billion of equity flows last month were below their 36-month average (+$35 billion). Magnitude was weak, but so was the breadth of flows. Only 51% of all equity funds had inflows in June, a hit rate well below the historical 63% median. The participation rate was also subpar, indicating a significant lack of conviction from investors — a view not all that surprising given the lousy market returns so far this year.
While the pace of equity flows fell below average, the more startling drop came from bond ETFs. In May, bond ETF flows were the second most ever. Yet in June, the inflows of $5 billion rank 98th all-time and sit 66% below the trailing 36-month average. The drop in bond flows stems from significant weakness in credit sectors.
Asset Class Flows
A Focus on US Equities, but Not Sectors
US exposures once again took in the majority of equity flows. The $28 billion equates to 81% of all equity flows, a figure above the US’ share of equity assets (77%). This signifies how this large category was allocated above what its current market share would warrant. Simply put, investors overweighted the US — and had a preference for value strategies as that style had $10 billion of inflows last month.
Single-country funds appeared to have inflows. But last month’s strength is all driven by China, as funds focused on that nation had $4 billion of inflows. Given that single country had a net $2.4 billion of inflows in June, the rest of the countries within this category had outflows. Only 23% of the countries we separate flows into had inflows in June, and only 43% of single-country ETFs themselves had inflows last month — well below the historical 54% median hit rate.
US flows would have been higher if it were not for the trends within sector strategies. Driven by $8 billion of redemptions from cyclical sectors, the total $7 billion of outflows (defensives had inflows) in sectors pushed the Q2 2022 figure to be the second worst quarter ever — just behind the outflows witnessed amid the Fed-induced volatility from Q4 2018.
Equity Sector Flows
Defensive sectors had inflows in June, led by the $615 million into Health Care. And the continued preference for defensive sector exposures and the lack of interest in cyclicals has pushed the differential between the two to extremes (shown below).
Overall, the outflows in non-US regional funds, the overall negative activity from single-country funds (ex-China), and the poor sector flows reinforce this risk-off/hesitant sentiment buying behavior.
Rolling Three-Month Sector Flow Cyclical Minus Defensives Difference
Risk-off Tone in Bonds
Investment-grade corporate exposures had $3 billion of outflows and high yield posted $4 billion of outflows. This was high yield’s fifth month of the year with outflows, and 1H 2022 proved to be the category’s worst half ever (-$16 billion).
If the year were to end today, this would be the worst amount of outflows for high yield for any full calendar year. The negativity is not a surprise. Growth concerns and fundamental volatility have widened credit spreads, while rising rates have presented duration-related headwinds.
Government bond exposures tried to offset the negativity from credit sectors, taking in $12 billion in June — led by the $8 billion of inflows into the ultra-short/short-term segments. For the latter, that was the fourth most flows ever.
In fact, both the overall government bond sector and its ultra-short/short-term maturity bucket posted record setting flows for the first half. Overall, the bond flows depict a buying base not willing to express much risk in portfolios — credit or duration.
Fixed Income Sector Flows
Surfing in an Endless Summer of Volatility
Like the surfers in The Endless Summer, investors looking for the perfect wave — an asset immune to swirling risks — should be aware that it may require significant searching. The alternative: going to cash, which is equivalent to putting your board in storage. Instead, refocusing portfolios towards more resiliency may be an optimal approach.
Outlined in our recent mid-year outlook, this may lead to investors emphasizing high-quality value stocks in the core, a tactic reinforced by the fact that profitable inexpensive stocks have outperformed non-profitable expensive firms by 40% this year. And within fixed income, this means limiting duration (and with it, rate volatility and central bank hawkishness) in the search for yield.
Overall, a mix of high-quality value equity strategies along with floating-rate bond exposures are some of the potential ways to try and ride out the choppiness of our potential endless summer of volatility vibes.
1 Bloomberg Finance, L.P., as of June 30, 2022. Based on the return for the MSCI ACWI IMI Index and the Bloomberg US Aggregate Bond Index of a portfolio weighted 60% to equities and 40% to bonds.
2 Bloomberg Finance, L.P., as of June 30, 2022.
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.
MSCI ACWI Index
A market-capitalization-weighted stock market index that measures the stock performance of the companies in developed and emerging markets.
Bloomberg US Aggregate Bond Index
A broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
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