Stocks and bonds just posted their third consecutive quarter of negative returns, the first time ever both asset classes have posted three straight quarters of losses at the same time. Led by subpar equity flows (+$17 billion), ETFs posted below average flows (+$24 billion). Participation also was low; just 50% (vs. 63% normally) of all ETF had inflows.
In every run, there is always one mile that is the longest due to a more difficult terrain. For one of my favorite routes, the longest mile is my third. It features a winding, slowly upward sloping hill that puts me up on a higher plateau until an “easier” mile four.
Some calendar quarters also can feel longer based on the market’s path. And this past quarter was one of those long ones, as a macro triarchy of elevated inflation, restrictive monetary policies, and wanning earnings sentiment presented challenges.
Both stocks and bonds fell for the third quarter in a row, the first time this negative trend has occurred. And with commodities declining -4.75%,1 all three asset classes have now fallen for two straight quarters for the first time ever.
Despite these weak returns, ETFs are poised to post their second best flows ever for a year. However, that headline is more of a head fake than anything else. Looking beneath the surface reveals how sour investor sentiment has become.
Low Participation from Investors
Year-to-date ETF inflows for 2022 are $397 billion. Assuming the historical average Q4 flows of $115 billion, full-year flows could hit $512 billion – roughly $9 billion more than the current second best of $503 billion in 2020.
While notional figures may be high, participation has been significantly low. The percentage of funds with inflows in September was just 50%, the lowest figure since March 2020 and 13 percentage points below its long-term historical median rate. As shown below, this significant weakness extended across all major segments last month.
Low participation has been constant throughout the year. The average monthly percentage of funds with inflows is just 57.4%, the lowest calendar year figure over the past 15 years. Yet, despite this low participation, ETFs are on pace to post their second-most inflows for a year.
Few Funds Received Inflows in September
Sectors Hit Hard with Record Outflows
Exhaustion is more uniquely noticeable within sector flows. Sectors, in aggregate, had -$9.9 billion of outflows in September. This is the largest outflow ever for sectors, surpassing the -$9.6 billion from this May. The fact that 2022 has the two worst months ever for sector flows is extremely telling of the type of risk environment we have had to endure this year.
Sector outflows were not uniform, however. Cyclical sectors, led by Financials, posted the majority of outflows (-$7 billion). Technology and Communication Services added another $2 billion of outflows. Defensives, led by almost $1 billion into Utilities, posted meager inflows of $137 million.
For defensives, this marked the 11th month in a row of inflows – a record run that has also coincided with other defensive equity positioning. Low volatility equity ETFs had a record $4 billion of inflows in September, pushing their trailing three-month total to the 95th percentile.
Large sector outflows along with strong inflows into low volatility funds reflect the most dominant buying behavior trend right now: de-risking. As shown below, trailing 12-month flows for sector funds are now just $10 billion, a level in the historical bottom 25th percentile. Yet, while sector flows have fallen over the past few months, trailing 12-month low volatility flows have moved higher – rebounding off lows last year. And we have seen this trend before in 2018-2019.
Until market volatility abates (a strong expectation given the confluence of risk flash points, both macro and micro) this trend is unlikely to slow. Net sector outflows, some defensive sector inflows, and more flows into low volatility factor funds than into sector funds likely will continue.
Investors Shun Sectors In Favor of the Low Volatility Factor
Ultra-Short Bonds Lead Bond Inflow
Defensive positioning also was depicted in bond flows. Ultra-short defensive government bond ETFs took in their most ever (+$19 billion). This outpaced the prior record from March 2020. If not for ultra-short government bond funds, bond flows would have been negative.
In fact, only government and aggregate bond sectors had inflows last month. The other nine had outflows, a testament to the weak return environment featuring rising rates and widening credit spreads. The ultra-short inflows show a preference to limit both rate and equity risk.
Investors, however, also sought to limit credit risk, as investment-grade, high yield corporates, and bank loan exposures saw outflows of more than $1 billion each in September.
Despite rising rates, floating rate bank loan funds posted their worst month of outflows ever (-$1.9 billion) and have now witnessed four consecutive months of outflows. This is a curious allocation decision considering loans have outperformed core and high yield bonds by 542 and 651 basis points over the same time frame, respectively.2 The need to limit credit risk at all costs appears to have outweighed any relative strength.
Fixed Income Sector Flows
Nimble Footing Required Ahead
Geopolitical tensions and policy uncertainty in Europe are likely to foster additional cross-asset volatility, beyond what is coming for stocks and bonds. And that’s the crux of this current environment – any short-term rally likely will be met by ongoing volatility. We already have witnessed gains or losses of greater than +/-1% on 49% of the days this year, the third highest hit rate in the last 40 years.3
As a result, any rally will not be met with confidence until the market can find more sustainable and stable footing. Like my approach toward my “easier” fourth mile, investors looking to pick up speed and make up time as challenges subside, need to watch out for any rocky paving.
For portfolios, this means a continued emphasis on high-quality value stocks to navigate uneven earnings trails alongside a preference for high-quality short-term bonds featuring attractive elevated yields with minimal rate risks.
1 Bloomberg Finance, L.P. as of September 30, 2022 based on the return of the Bloomberg Commodity Index 2 Bloomberg Finance, L.P. as of September 30, 2022 based on the return of the Morningstar LSTA Leveraged Loan Index, the Bloomberg US Aggregate Bond Index, and the Bloomberg US Corporate High Yield Index 3 Bloomberg Finance, L.P. as of September 30, 2022 based on the return of the S&P 500 Index
Bloomberg Commodity Index Calculated on an excess return basis and reflects commodity futures price movements.
Bloomberg US Corporate High Yied Index Tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
Morngingstar LSTA Leverage Loan Index An index of below investment grade senior loans.
S&P 500® Index A market-capitalization-weighted stock market index that measures the stock performance of the 500 largest publicly traded companies in the United States.
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