Rising Rates Rain on Investor Sentiment
- Sentiment remained sour in September. ETF inflows were only $38 billion, 32% below historical averages.
- Investors dialed back risk. Emerging markets, Europe-region, and single-country ETFs had outflows. Sectors had $7 billion of outflows.
- Bonds’ $10 billion of inflows showed a defensive mindset. Government exposures took in $9 billion while credit sectors saw $5.2 billion in outflows.
The state of Massachusetts saw 3.5 inches of rain in September — our fourth month in a row with above average rainfall following what was the rainiest summer since 1995.1 Just as the above average summer rainfall in the Northeast has ruined pumpkin crops and dampened typical fall festivities, rising rates have rained on bond and stock returns over the past few weeks.
Higher-for-longer rates have permeated capital markets well beyond bonds and transformed stock rallies into a downpour of drawdowns. And the dual sell-off in stocks and bonds has sent their cross-asset correlations higher, negating any perceived long-term diversification benefits in the near term.
As of right now, their rolling 90-day correlation of daily returns sits in the 85th percentile over the past 35 years — spiking sharply from the 13th percentile at the start of June, when rates rose and the rain started to fall.2
With global stocks and bonds falling in unison on the month and quarter, the lackluster buying behavior so far this year went unchanged in September. And investors’ de-risking and defensive mindset served as an umbrella to rising rates raining on returns.
Buying Behavior Restrained in September, Again
ETFs’ $38 billion of inflows were roughly 32% below the historical average monthly total (+$56 billion). This marks the eighth month out of nine this year when monthly net flows were below average — showing investors’ restraint and lack of conviction in current market return trends.
Equity ETFs took in nearly $30 billion in September, accounting for over 78% of all fund flows last month. But equity ETF flows were still below their historic monthly average of $40 billion.
Bond ETFs added almost $10 billion last month, well below their historical monthly average of $17 billion. For the full year to date, bond ETFs are averaging $16 billion a month — a pace that would project full-year figures to be close to breaching the $200 billion barrier.
While both categories show weakness, the trends relative to each other show even more retirant. When comparing rolling 90-day flow differentials between equity and bond ETFs, it’s clear that investors are hesitant to express risk. After having moved higher at the start of the summer, the rolling 90-day average sagged and is now at the long-term median, as shown below.
Commodity flows didn’t help the headline number in September either, as they posted outflows once again this month. They now have almost $7 billion of outflows this year.
September flows were dragged down by the $2 billion of outflows in precious metal exposures, namely gold-related ETFs. Broad commodity funds offset that weakness with $330 million of inflows — ending a record run of 12 consecutive months of outflows.
Figure 2: Weak Flows Across Asset Classes
| In Millions ($) | September | Year to Date | Trailing 3 Month | Trailing 12 Month | Year to Date (% of AUM) |
|---|---|---|---|---|---|
| Equity | 29,757 | 201,347 | 84,294 | 331,786 | 4.00 |
| Fixed Income | 9,843 | 137,915 | 39,158 | 212,929 | 10.61 |
| Commodity | -1,650 | -6,871 | -7,137 | -12,285 | -5.19 |
| Specialty | 229 | -37 | 784 | -428 | -0.73 |
| Mixed Allocation | -96 | -2,064 | -81 | -922 | -10.70 |
| Alternative | 311 | 1,025 | 818 | 1,456 | 18.59 |
Source: Bloomberg Finance, L.P., State Street Global Advisors, as of September 29, 2023. Top two/bottom two categories per period are highlighted. Past performance is not a reliable indicator of future performance.
Preference for US-Focused ETFs Doesn’t Extend to Sectors
US-focused exposures’ $29 billion represented 96% of all equity inflows by geography last month, as investors had an extreme preference to allocate to US equities over the rest of the world. And unlike the above commentary on below average headline flow figures, US ETFs’ $29 billion is actually above their historical average rate of $27 billion — meaning the rest of the equity world didn’t contribute.
Beyond the focus on broad developed exposures, there was little interest to venture overseas and express specific directional risk bets. Emerging market ETFs had over $1 billion of outflows for the second month in a row.
Figure 3: Geographic ETF Flows Signal Limited Interest to Go Overseas
| In Millions ($) | September | Year to Date | Trailing 3 Month | Trailing 12 Month | Year to Date (% of AUM) |
|---|---|---|---|---|---|
| US | 28,715 | 140,618 | 74,032 | 234,232 | 3.57 |
| Global | 921 | -378 | 1,792 | 7,124 | -0.22 |
| International – Developed | 3,088 | 38,517 | 10,589 | 55,680 | 6.85 |
| International – Emerging Markets | -1,302 | 8,242 | -1,215 | 16,814 | 3.85 |
| International – Region | -1,186 | 5,373 | -3,673 | 5,745 | 9.69 |
| International – Single Country | -877 | 6,119 | 1,526 | 9,342 | 6.68 |
| Currency Hedged | 382 | 2,036 | 838 | 1,941 | 28.19 |
Source: Bloomberg Finance, L.P., State Street Global Advisors, as of September 29, 2023. Top two/bottom two categories per period are highlighted. Past performance is not a reliable indicator of future performance.
While the US saw the stark majority of flows, its sectors were not in favor. Just two sectors had inflows last month: Energy and Consumer Discretionary. The Energy inflows were supported by a surge in oil prices, as brent crude rallied almost 10% on the month.3 This supported underlying firm price momentum as the Energy sector was up 2.5%, while the rest of the US equity market was down almost 5% in September.4
All other sectors posted outflows, leading to sectors in the aggregate to post over $7 billion of outflows. This is the fifth-worst month of sector outflows ever — a stark indicator of investors’ lack of conviction in this market.
There was no distinction between defensive or cyclical sector flow patterns either. Defensives posted $3 billion of outflows in September, led by the outflows from Health Care and Consumer Staples. This was their second-worst month of outflows ever. Cyclicals weren’t too far behind, posting $1.2 billion of outflows.
This is now the second consecutive month where both cyclicals and defensives posted outflows at the same time. A change in sentiment is needed to avoid both sector types posting outflows three months in a row for the first time ever.
Figure 4: Sector ETF Flows Fifth Worst Ever
| In Millions ($) | September | Year to Date | Trailing 3 Month | Trailing 12 Month | Year to Date (% of AUM) |
|---|---|---|---|---|---|
| Technology | -1,456 | 4,222 | 2,400 | 6,433 | 2.85 |
| Financial | -1,884 | 321 | -2,038 | 9 | 0.52 |
| Health Care | -1,555 | -7,302 | -2,880 | -3,776 | -7.02 |
| Consumer Discretionary | 944 | 5,056 | 2,077 | 4,414 | 22.11 |
| Consumer Staples | -1,494 | -1,407 | -1,753 | 585 | -4.47 |
| Energy | 942 | -8,570 | 2,628 | -7,737 | -9.89 |
| Materials | -920 | -2,236 | -761 | -1,610 | -6.10 |
| Industrials | -321 | 1,498 | 753 | 2,285 | 4.46 |
| Real Estate | -91 | -2,559 | 711 | -2,288 | -3.65 |
| Utilities | -474 | -870 | -811 | -2,013 | -3.33 |
| Communications | -1,047 | 2,317 | 298 | 2,669 | 20.09 |
Source: Bloomberg Finance, L.P., State Street Global Advisors, as of September 29, 2023. Top two/bottom two categories per period are highlighted. Past performance is not a reliable indicator of future performance.
Bond ETF Flows Driven by Defensive Positions
Bonds took in just $10 billion in September, but 92% of those flows were driven by the $9 billion government bond exposures (with $5 billion going to ultra-short bonds). That percentage is noteworthy as the broader government bond category makes up only 25% of total bond ETF assets.
Ultra-short and short-term government bonds have been the main driver of full-year flows as well; their more than $40 billion equates to almost half of all government bond flows this year. This reflects investors’ tactical allocation decision to: 1) de-risk and 2) seek improving income as the Fed pushes forward with its higher-for-longer narrative.
De-risking meant credit sensitive exposures were shunned. Investment-grade bond exposures saw $3.7 billion of outflows, a stark reversal of the year-to-date trend. High yield lost $1.5 billion and now has over $5 billion of outflows in 2023. Loan ETFs, however, have had inflows for two consecutive months, with almost $1 billion of inflows over the past three months.
Figure 5: Bond ETF Flows Indicate Risk Off Positioning
| In Millions ($) | September | Year to Date | Trailing 3 Month | Trailing 12 Month | Year to Date (% of AUM) |
|---|---|---|---|---|---|
| Aggregate | 4,304 | 48,418 | 10,555 | 65,359 | 11.75 |
| Government | 9,076 | 85,368 | 25,775 | 109,432 | 30.49 |
| Short Term | 4,755 | 41,438 | 11,025 | 53,262 | 25.42 |
| Intermediate | 2,271 | 17,583 | 7,064 | 22,706 | 20.51 |
| Long Term (>10 yr) | 2,050 | 26,346 | 7,685 | 33,464 | 58.02 |
| Inflation Protected | -461 | -11,480 | -2,477 | -17,970 | -14.73 |
| Mortgage Backed | 458 | 7,712 | 1,886 | 11,433 | 15.43 |
| IG Corporate | -3,753 | 5,948 | -2,180 | 15,393 | 2.62 |
| High Yield Corp. | -1,468 | -5,460 | -786 | 5,824 | -8.28 |
| Bank Loans | 535 | -1,378 | 815 | -1,629 | -10.35 |
| EM Bond | -267 | 489 | -351 | 1,475 | 1.83 |
| Preferred | -168 | 61 | 92 | -917 | 0.19 |
| Convertible | -169 | -526 | 359 | -407 | -8.49 |
| Municipal | 1,413 | 6,327 | 4,455 | 22,136 | 5.96 |
Source: Bloomberg Finance, L.P., State Street Global Advisors, as of September 29, 2023. Top two/bottom two categories per period are highlighted. Past performance is not a reliable indicator of future performance.
Strategic Flows Dominate Amid the Lack of Market Direction
Active ETFs took in $11 billion in September — and have now taken in more than $100 billion over the past 12 months. Active equity drove inflows last month. For active equity, August’s $8 billion extends their record run of inflows to 46 consecutive months — a streak that has witnessed total assets rise to nearly $280 billion.
Given this dynamic, active as an overall category has taken in 26% of all ETF flows this year — despite representing only 4% of all ETF total assets under management.
At the same time, low-cost ETFs have taken in $202 billion this year, bifurcated by $130 billion in equities and $72 billion in fixed income. This equates to 61% of all ETF flows, despite low-cost ETFs only representing 45% of all ETF assets.
As a result, given the lack of market direction this year, two of the more strategic types of allocation exposures (active and low cost) comprise 87% of all flows this year, with strong representation across asset classes (Figure 6 below).
Don’t Try to Run Between the Raindrops, Find an Umbrella
Although stocks have sold off alongside bonds, higher rates have not rained on earnings sentiment. Earnings revisions are holding up amid the cloudy macro backdrop.
Yet, if the bar has been set too high and firms disappoint, October price trends could be the same as what we saw in September. And investors will head deeper into the fall like Guns N’ Roses’ Axel Rose — walking in the cold November Rain.
The opportunities in bonds are a bit more balanced. With rates moving higher, core bond yields are now more in line with their duration, as the yield-per-unit of duration is 0.90.5 This more balanced breakeven ratio is now above its long-term average for the first time since 2009.
That means core bonds’ coupon/yield can help them withstand further upward movements in rates without immediately incurring a total return loss from duration-induced price declines.
If fundamental durability can’t be an umbrella to the macro rainstorms that have plagued capital markets since mid-August, how can investors stay dry?
One tactic may be structuring portfolios to remain invested with lower market risks.
This means considering:
- Equity strategies with an imbedded factor bias toward Low Volatility but with sufficient upside capture due to a mix of return-seeking factors like Quality and Value.
- Active core bond mandates, both in the core and at the shorter end of the curve, that can seek out attractive income opportunities while balancing macro risks
For more insight into ETF flows along with the latest charts, scorecards, and investment ideas, visit Market Trends.