May Flash Flows: Feeling the Heat

Elevated cross-asset volatility and shifting macro forces have created a more complex market environment in 2022, leading to a shift in buying behavior. Bond ETFs posted their second best flows ever, and as a result of subdued equity flows, the rolling three-month differential between stock and bond flows has fallen significantly.

As a result of the multiple dimensions of risks converging on top of one another, equities are down significantly this year. As of right now 65% of all global stocks are trading in a bear market, even after the best weekly rally in 18 months during the last week of May.¹

The complexity of this current environment can be quantified by comparing current implied volatility levels; as the average percentile rank for measures of implied equity, as well as bond, currency, and oil volatility are all above the 90th percentile – reinforcing how widespread risks have become.²

These cross-asset risks pressuring markets and the traditional portfolio got me thinking about one of my favorite scenes from the thrilling 1995 bank heist movie, Heat and the famous quote about how the “action is the juice”.

This turn of phrase couldn’t be more appropriate when putting the recent bout of market volatility in perspective. Risk assets earn a premium for a reason. The action (volatility) provides the juice (returns). As a result, without any volatility premium, risk assets like stocks and credit would essentially behave like, and earn, the risk-free rate.

Flow trends reflect a lack of risk-taking by investors amid this uptick in action and cross-asset volatility.

Change in Behavior

Stock funds have outpaced bond funds by $25 billion over the past three months. However, over the past two months bond inflows have been greater than equity inflows, as equity sentiment has slowed and flows into fixed income exposures surged. In fact, May’s $34 billion of bond inflows ranks second all-time and is three times greater than bond funds’ historical median level.

Equities had a below average $38 billion of inflows in May. Yet, after bearing the brunt of the outflows in April, US equity funds led all geographic regions in May. US-focused exposures took in $36 billion last month, a $60 billion difference from April’s $27 billion of outflows. Non-US flows were dragged lower by over $1 billion of outflows from global and regional equity focused ETFs.

Given this change in buying behavior, the rolling three-month fund flow differential between stocks and bonds has fallen. It still favors equities, but is now in the 49th percentile, at $21 billion. A few months ago, the difference was over $150 billion, and it has been above the 80^th percentile for seven consecutive months, as shown below.

The reduction in sentiment can also be felt by the overall lack of investment. While not all investors have de-risked, many have stopped allocating capital for the moment – hesitant to make a move amid the action. The percentage of funds with inflows in May compared to the historical median positive fund flow rate is illustrated below. And in every category, all funds are below their median – some significantly so.

Sectors Hit Hard

Sector funds, in the aggregate, posted outflows of nearly $10 billion in May. This is the worst month of outflows ever. Cyclical sectors, namely Financials (-$5 billion) and Industrials (-$2 billion), primarily drove the outflows. Overall, outflows in the aggregate, and from cyclicals, represent significant de-risking.

The notion of defensive, risk-off posturing from sector investors is heightened by the allocations that did receive inflows in May. Led by $1.8 billion of flows into Health Care, defensive sectors (Utilities and Consumer Staples as well) had over $2 billion of inflows. This matches what we saw from a style perspective, as value oriented, quality biased dividend funds took in the most flows ever in May (+$9.8 billion).

While cyclicals have posted their worst ever three-month period with $20 billion of outflows, defensives have now posted their best three-month period of inflows – amassing $12 billion. As a result, and show below, the differential is at its worst ever – well below the historical median in addition to the 20^th percentile.

Bonds Get a Boost

Bond funds nearly broke records in May due to strong flows into government bond exposures. Government funds took in $18 billion in May, led by $12 billion into ultra-short government strategies.

Given that ultra-short funds have little to no duration risk,³ and still have a negative correlation to stocks,⁴ their use at a time when bond and equity volatility is elevated is not surprising. In fact, this has been a trend for the past three months when these funds have taken in over $22 billion. This is their second- highest three-month total ever – $2 billion shy of the prior record set in December 2018 when the S&P 500 Index narrowly escaped a bear market.

Even though only 61% of fixed income ETFs had inflows in May, there was strength beyond ultra-short government funds. Of the eleven major bond sectors we track , seven had inflows. In a potential sign of moderate dip-buying, investment-grade and high yield corporate bond ETFs took in a combined $7 billion last month. This was the first month of inflows for high yield in 2022, reversing their year-to-date trend of sizeable outflows.

When There Is Heat Around the Corner

Given the broader backdrop, it’s not going to be just “barbecues and baseball” this summer. Investors should expect more action and angst to keep them on edge. With that in mind, focusing on areas that may be able to withstand the complexity of converging macro (rising rates, inflation) and fundamental risks (uneven growth and waning sentiment) may be beneficial.

This includes placing a greater emphasis on attractively valued firms that exhibit lower relative fundamental volatility, limiting duration headwinds in pursuit of real income with floating rate exposures and ultra-short active strategies, as well as expanding portfolios to include inflation-sensitive alternatives such as gold, natural resource producers, and commodities.