As we discussed moments ago, the price action in fixed income has driven dramatic shifts in ETF flows over the last week, suggesting that material moves are taking place under the surface. :
- Government Bond and Credit (largely HY) ETFs posting 3 to 4 z-score outflows
- Growth and Momentum equity products saw 1 to 2 z-score outflows
- US equity sector flows also show sensitivity to rates with Utilities and Real Estate positing ~3 z-score outflows, even more than Technology which saw 2 z-score outflows
And, as Morgan Stanley’s quantitative derivatives strategist Chris Metli explains in a note to clients, the direction of these flows is not all that surprising – but it’s helpful to put into context the magnitude of the flows. Across all fixed income ETFs, the last week saw the biggest outflows since the taper tantrum.
Credit products saw more outflows than government bond products, although given that HY has traded reasonably well the outflows are likely motivated more by the rate than the spread component.
Yet contrary to market speculation, within equities there does not appear to be a huge rotation into Value – the more notable flow is selling of Momentum and Growth ETFs, which we noted earlier.
Similarly on the sector level ‘Value’ sectors like Financials, Materials, and Staples have not seen big inflows – the more notable flow is selling of Technology (in-line with the Momo and Growth outflows) as well as outflows from the rate-sensitive Real Estate and Utilities sectors (note for the below charts the flow over the last week is on the horizontal axis, while the positioning vs the last year is on the vertical axis).
What is even more curious, is that the outflows from Utilities and Real Estate do not line up with price action over the last week – in fact Utilities and Real Estate actually outperformed what a simple sector model based on SPX and 10y rates would have predicted. As we noted earlier this week, MS equity strategist Mike Wilson said that these moves suggest investors are taking the view “that the rate spike is ultimately growth negative in that it destroys demand.”
Here’s why this matters: according to Morgan Stanley, for now, the rotation into defensives – despite the rate move – is keeping a lid on correlation between stocks and is slowing a move lower in the broader indices. But if the rate impact starts to dominate the defensive bid and the flows out of defensive ETFs continue there are important implications – dispersion between stocks will fall, correlation will rise, and volatility for multi-asset investors (including risk parity funds) will spike.
As Morgan Stanley warns in parting, “this dynamic – that there could be no safe haven within equities to turn to as rates rise – is the ultimate bear case for risky assets.”
While price action indicates we are not there yet, these flows suggest that unless the violent rotation fades, “extreme caution for stocks is still warranted here.”
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