Digging Ourselves Out of This (Jackson) Hole

• The Hawkish tone from the Jackson Hole Economic Symposium was a stark reminder of the reality of today's market: Controlling inflation is still the primary target for the Federal Reserve (Fed) and the economy may have to bare economic pain to achieve that.
• While equity flows accelerated from the prior month (+$29.4 billion vs. +$12.9 billion) participation remains low; just 56% of equity ETFs had inflows versus 62% on average.
• Largely led by Financials, sector flows reversed a three-month streak of outflows, bringing in $8 billion, the eighth-highest monthly inflow in 15 years.
• Most of the $23 billion of inflows into bond ETFs was split between aggregate and government funds, indicative of defensive posturing of investors.

The summer market rally observed these past few months seemingly ended following Chairman Powell’s Jackson Hole speech, when he showed the central bank’s determination to bring inflation back to target by “maintaining a restrictive monetary policy for some time,” even if that may bring “a sustained period of below-trend growth.” Markets responded to the hawkishness with lower equity prices and higher yields. The S&P 500 dropped 4.1% in August, crossing below its 100-day moving average and halving the rally it witnessed in July.¹ Rates expectations for next year were adjusted dramatically higher, close to the FOMC’s median projection in June. Treasury yields moved higher across the term spectrum, with 10- and 2-year spreads inverting further.²

Although ETF flow momentum picked up from its July lull, with US-listed ETFs in aggregate seeing $44.5 billion in inflows during August, defensive positioning was observed under the hood.

Looking Beyond the Behemoth

The US was the primary target of inflows in August, taking in $33.6 billion to place in the top decile over the past 15 years. As the US dollar reached a 20-year high,³ investors shunned non-US equities to the tune of $902 million of outflows, ending a 26-month streak of inflows.

Emerging market (EM) ETFs had their 23rd consecutive month of inflows — the longest streak ever, despite being down almost 7% on a trailing-three month and 18% on a year-to-date basis. Flow momentum continues to slow, however, with inflows these past two months 80% below the average during this record run.

Single-country funds ended the month down $2.2 billion, reversing their trailing-three month activity to net outflows. The majority of the outflows came from $1.2 billion in outflows from China-focused funds. Growth prospects in China remain underwhelming even with easing monetary policy, as stringent COVID-19 restrictions, weakening manufacturing fundamentals, and geopolitical headwinds add pressure.

Defensives Beat Cyclicals Beneath the Surface

Sector exposures are an effective segment to depict investor behavior, given their multiple use cases and tactical nature. In August, aggregate flows reversed a three-month negative streak, bringing in $8 billion, the eighth-highest monthly inflow in 15 years.

Cyclical sectors in aggregate led the charge thanks to strong inflows to Financials amid rising yields.⁴ Excluding Financials, cyclical sector flows in fact were negative $522 million. Meanwhile, investors are still taking positions in defensive sectors. August saw Consumer Staples and Utilities – two sectors that have historically had stronger market returns than other sectors during slowdowns and recessions – take in more than $800 million each.

While the strong inflows to Financials pushed up the cyclical minus defensive flow differential from its extremely low level, it is still well below its bottom quintile in the 15-year lookback window.

Bonds Bought

The strong bond flows were supported by eight out of the 11 sectors we track registering inflows on the month. The majority of flows into bonds were split between aggregate and government funds, indicative of the defensive posturing of investors.

With risks to growth skewed to the downside given potentially longer-than-expected restrictive monetary policy, investment-grade corporate bond funds were sought after. On the other hand, high yield bond funds registered outflows over all reported time periods with $3.1 billion in outflows in August alone. This coincides with the widening of high yield credit spreads, from 407 bps to 475 bps over the course of past two weeks.⁵

Whether the Fed will pause on hiking next year depends on whether the incoming inflation data show a consistent and evident downward trend for the next few months. While decelerating PMI, easing supply chain pressure, and recent cooling commodities prices are pointing to the right direction, the labor market remains extremely tight with wage inflation far above the historical trend. If the Fed keeps tightening to cool down the labor market and reign in wage inflation, the recession risk may replace inflation as investors’ major concern. Long-duration assets may find some support, while cyclical exposures may come under pressure.

Tightening monetary policy and growth uncertainty will likely continue to create an extremely volatile market environment. Seasonality is not in favor either, as September historically is the worst month of the year for returns, with an average of -1.03%.⁶ Given these headwinds, investors should bulk up heading into the fall season, focusing on portfolio diversification with high-quality value within equities, ultra-short-duration and long-duration bonds, as well as real assets.