Risk appetites returned as rates fell and global equities rallied 8% to finish above their 200-day moving average for the first time since March. Flows somewhat matched the risk-on tone as ETFs took in $56 billion, on par with November averages. Yet, bonds drove inflows with their seventh-most ever (+$27 billion), and within equities there is still a preference for defensive sectors (+$3.6 billion) and dividends (+$ 5 billion).
Tides are one of the most reliable spectacles in the world. A tidal cycle, the time between high and low tides, lasts roughly 24 hours and 50 minutes, as tides are just very long-period waves that move through the ocean in response to the forces exerted by the moon and sun. But more than two factors determine the tides, and therefore tidal prediction.
The shape of shorelines, bays, estuaries, local winds, and weather patterns all affect tides. And not all tides are felt the same around the world. The Bay of Fundy has a tidal range (the difference between the height at high versus low tide) of over 53 feet, while in the Caribbean it can be just eight inches.
Most areas experience two high tides and two low tides each day. Yet, some areas experience only one of each — requiring more patience and planning by local seafarers and beachgoers. The same level of attention may be warranted from investors as we head into 2023.
Higher rates combined with ongoing macro uncertainty is one reason why the tides of 2022 were so choppy. But lately, the hope for a pause in hikes has been a strong tidal force — and why the markets rallied in November.
Above average November inflows, led by bonds and defensive equity exposures, illustrate that investors responded to renewed pivot hopes with tepid optimism.
Despite the stronger return in equities over these past three months, bond funds have been one of the bigger drivers of this accelerated pace. Bond funds have had back-to-back months of inflows over $25 billion, monthly figures in the top ten all-time. As a result, their rolling three-month total is in the 97th percentile, good for a top five ranking. .
This recent run has pushed total 2022 bond inflows to $179 billion, making surpassing $200 billion for the third straight year possible when it was a slim hope at the start of the quarter when the category was $75 billion away. With $25 billion-plus in December, 2022 could join the $200 billion bond flow club alongside 2020 and 2021.
The resurgence of bond inflows has had depth (only two sectors had outflows last month), but a key driver has been the double-fisted buying behavior in high yield. One month after posting their second-most inflows ever, high yield followed up taking in their fifth-most ever (+$6.2 billion). Investment-grade corporate bond exposures have also helped topline bond flows, adding $5 billion last month.
While credit allocations have increased, it hasn’t been to the detriment of risk-off positioning. Government bond exposures took in $4 billion in November and have the largest flow totals of any bond sector in the past three months (+$40 billion).
Fixed Income Sector Flows
The strong back-to-back months of inflows for high yield has pushed rolling three-month totals to the historical 97th percentile and fifth-most all-time. But high yield has more fundamental headwinds.
Credit spreads are not constructive. In fact, single-B rated, double-B rated, and broad high yield all have spreads well below their 20-year averages.1 There is also weak ratings sentiment, as downgrades have outpaced upgrades in 2022.2
The lack of fundamental flexibility is a major reason why investors may want to be cautious on credit. And as shown below, the reversal of flows back into high yield was more of a give back from the large negativity earlier in the year.
Rolling Three-Month High Yield Flows ($ Billions)
Sector funds (+$5 billion) had inflows for the second consecutive month, but continue to be led by defensive segments.
Defensive sectors had $3.6 billion of inflows, their ninth-most ever and record-setting 13th month in a row with inflows. Health Care (+$2.7 billion) and Consumer Stapes (+$1.2 billion) were the main areas of interest.
Given that leading economic indicators are falling deeper into negative territory, flashing warning signs of a recession, and that additional earnings downgrades are highly likely, this defensive bias may continue. And this includes the focus on dividend paying firms by investors, as those funds took in $5 billion in November – their 27th month in a row with inflows.
While the bias is toward defensive sectors, cyclical allocations have taken place. Cyclicals had inflows in November, following $3 billion of inflows in October.
While the trend for cyclicals has improved, it really had nowhere else to go after hitting an all-time bottom this year. Some of this is a mean reversion from 2021, as shown below. Looking ahead, cyclicals overtaking defensives will be rooted in how quickly the Fed pivots.
Rolling Three-Month Sector Flows ($ Billions)
Within equities, there was a stronger emphasis to look outside the US, as non-US exposures (+$15 billion) took in 47% of all November equity inflows, despite having a 21% market share of assets. Emerging market ETFs took in $4 billion and China single-country funds added $1 billion as those markets strongly rallied last month.
Yet, outside of the multi-billion dollar notional flows, the relative positioning figures also indicate a buying behavior shift — particularly for emerging markets as a result of the potential for a less restrictive COVID policy in China.
Emerging market exposures witnessed a 2.3% increase in their start-of-month assets, and single-country funds (42% driven by China flows) had a 3.1% increase.
The China reopening trade was also evident by examining the single-country flows. While China drove 42% of the single-country inflows in November, associated Asia nations such as Taiwan (+$575 million), South Korea (+$337), and India (+$144 million) primarily made up the difference.
Equity Geography Flows
At some point, aggressive central bank tightening will ease, as the extreme hikes work their way into the economy. Earnings sentiment also will find a bottom as companies and analysts fully price in the new rate reality, and its impact on margins, consumption, and revenue streams.
But we are not there yet. Earnings sentiment is likely to worsen, as projections for next year have yet to fully reflect the margin weakness. And as far as central bank policy is concerned, the pivot is more hope than reality at this point. Markets expect another 100 basis points of rate hikes through the March FOMC meeting to push the fed funds rate to 5%.3
As a result, markets will be caught between two tides in 2023 — hoping for a pause on the Federal Reserve’s (Fed) aggressiveness, while fearing the impact of worsening growth sentiment.
Sturdy sea legs will be necessary. As outlined in our 2023 outlook three strategies can help investors navigate these shifting tides of optimism and pessimism:
1 Bloomberg Finance, L.P. as of November 30, 2022 based on the ICE BoFA US High Yield Index and their associated rating bands.
2 Bloomberg Finance, L.P. as of November 30, 2022 based on S&P ratings.
3 Bloomberg Finance, L.P. as of November 30, 2022 based on Fed Funds futures.
ICE BoFA US High Yied 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.
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