Sensing Some Angst in February’s ETF Flows

Following inflation surprises and calls for higher policy rates, global stocks and bonds posted losses in February. As a result, ETFs had just $9 billion of inflows last month and are off to their worst start since 2019. US equity ETFs were a source of weakness, posting $3 billion of outflows. But non-US funds had $9.5 billion of inflows — led by regional funds posting $3.7 billion, their ninth-best inflow ever. Bond ETFs had $4.2 billion of inflows; only ultra-short government and aggregate funds recorded inflows.

In 1991 Nirvana released their second album Nevermind. Many believe the lead single “Smells Like Teen Spirit” ushered grunge rock into the mainstream consciousness. And the song, as well as video, quickly became an anthem for dissatisfied teens searching for identity and purpose.

The market’s activity and buying behavior during February evoke the song’s angst. When inflation surprised to the upside and the Federal Reserve (Fed) recommitted to its aggressive rate hikes, moody investors retreated back to their bedroom like sullen teenagers upset with strict parents.

Lacking Conviction

Investors’ rebellious nature is strikingly evident in ETF fund flow trends. Stock and bond funds had inflows 85% and 90% below their longer-term monthly averages, respectively. Meanwhile commodity, specialty, and alternative funds had combined net outflows.

As a result, ETFs had a frustratingly low inflow total of $9 billion in February. This was the weakest month of inflows since August 2019, not accounting for ETFs’ outflows in April of 2022. This is also the weakest February inflow since 2018 (i.e., during Volmageddon)¹ and 50% below February’s historical average.

The subdued February flows, combined with below-average flows in January, have led to one of the weakest start to a year ever. The two-month total of $49 billion is the worst two-month start to the year since 2019, as shown below. Back then, the market was mired in a drawdown and the Fed was raising rates, not unlike today.

Yet, the market has been in this situation for the better part of a year and still saw strong inflows in 2022. The change in buying behavior and lack of conviction to start 2023 is a result of the recent inflation surprises and labor market durability that forced the market to re-price/reassess the timing of when Chair Powell would turn into Mr. Brightside and stop hiking rates.

Two months do not make a trend. Yes, a fast start would be better, as the year with the best first two months (2021) went on to post record flows. But a slow start does not necessarily mean flows are destined to traverse a boulevard of broken dreams all year. For example, 2016 began with just $1 billion of inflows, but ended with almost $300 billion.

So it’s a bit premature to call for a full year of flow melancholy and infinite sadness. Taking a “longview” like Green Day is more beneficial.

Non-US Equity Flows Are a Source of Optimism

Non-US equity flows were the lone bright spot within the equity category. Those funds took in almost $10 billion last month, raising their year-to-date total to over $29 billion.

This far outpaces the -$3.5 billion of outflows from US equities, one of the biggest losers in terms of flows. US equities had $3 billion of outflows last month, and now have had outflows in two consecutive months. Back-to-back months of outflows for US equity exposures hasn’t occurred since the start of 2018.

Regional funds, mainly focused on European equities, drove the strong non-US flows. Those strategies took in $3.8 billion February, their ninth-best month ever and reflective of investors’ heightened interest overseas. This is a tactical trade that has been rewarded so far this year, as international-developed stocks have outperformed US exposures by 2% so far in 2023.²

Geography Flows

This momentum toward overseas allocations in lieu of US centric positions has been building for a few months now. The rolling three-month differential for non-US equity positions has been steadily climbing since last October. And with non-US outpacing the US by $10 billion February, the differential has turned noticeably positive, as shown below. In fact, this is the largest positive differential for non-US versus US since early 2018.

Sectors Signal Risk-Off

With markets striking a risk-off tone, risk levels were taken down and sectors had outflows. Nine out of 11 sectors had outflows last month, with Industrials and Financials the only areas with inflows. Interestingly, cyclicals and defensives now both have net outflows on a rolling three-month basis — the first time this has happened since 2019.

Options markets confirm the risk-off sentiment, as total put-call open interest currently sits in the bottom 13^th percentile for sector funds over the past three years.³ This indicates a lack of leverage and overall risk-taking, especially considering call open interest is severely depressed as it resides in the lower fourth percentile.⁴

Short interest data also confirms the lack of risk expressed. After all, a short position is an active risk bet, even if it is to hedge a long allocation elsewhere. And short interest declined for ten out of the 11 sectors over the past month.⁵

Sector Flows

Bond Flows Back-Up the Risk-off Vibes

Bond flows were a bittersweet symphony. The total figures were positive, as bond funds took in $4 billion last month. However, only two areas really drove those flows. Aggregate funds had over $8 billion while ultra-short term government bond ETF had $11 billion. This is their fifth-best move ever and not a surprise given the elevated yields for that part of the yield curve.

Active fixed income funds added $3.4 billion in February, partially offsetting some of the weakness in the total bond category. Yet, $3 billion of that was in active aggregate based funds. Overall, outside of those two main bond sectors, total bond flows were -$14 billion — the lowest flow total since March 2020.

Bond Flows

Investors said good riddance to credit last month, as high yield bond exposures led the bond outflows by posting $7.7 billion of outflows in February. This is their worst month of outflows ever, narrowly eclipsing the -$7.5 billion January of 2022 and partially unwinding the $11 billion of inflows over the prior four months. As shown below, rolling three-month flows are now -$9.8 billion, the second-worst level ever

Balancing Hope and Angst

While multiple factors caused both stocks and bonds to give back gains from January, the risk off mood is almost entirely based on the change in policy perceptions and what it did to interest rates. With January’s hope and optimism fading to melancholy and angst in February, the question has become which mood reflects the long-term view?

Given January’s rally was mainly driven by high beta, high short interest, and low-quality stocks, that level of optimism was probably not sustainable. This doesn’t mean, however, that February’s negativity is the new baseline.

Expect the up-and-down of emotions to continue, with this grunge-era temperament likely to remain until the Fed fully changes its tone, as valuations are unlikely to vastly improve and earnings trends are far more recessionary than expansionary. Any Fed pivot is likely to occur sometime around the Jackson Hole Symposium, which in the past has acted as a major policy setting event.⁶ A more dovish tone at Jackson Hole could end investors’ current cynical and temperamental mood the same way the emergence of bubbly teen pop idols like Britney Spears and the Backstreet Boy ended the grunge era.

Overall, despite the uptick in cross-asset volatility and renewed uncertainty over the policy path ahead, youthful optimism that things will all work out in the end infuses our 2023 market outlook. We continue to suggest that investors balance offense and defense within equities while managing duration on the hunt for income in bonds.