Issue 57: 2016 06 09: Follow the money (Frank O’Nomics)

09 June 2016

Follow the money

by Frank O’Nomics

This year hasn’t really been that bad, at least so far, from an investment point of view.  Despite a very difficult start, most asset classes have shown positive returns, some of which have been very healthy.  This has been a very pleasant surprise but, as we approach some significant political and geo-political events, it is reasonable to ask whether these returns can be sustained and which areas continue to offer reasonable prospects.  As we approach first the EU referendum, and then the US election, markets are likely to be very cautious, displaying short-term volatility due to poor liquidity, which is in part seasonal but largely event driven.  We have already seen an uptrend lapse into something of a general sideways move for most assets.  The economic outlook, both domestic and global, will as ever have a key role to play in dictating future returns, but so too will the general flow of funds and it is well worth keeping an eye on these to get a pointer towards future returns.

First we should look at the winners and losers so far.  The good news is that the only losers of note have been Japanese equities (down not far short of 10%) and, to a much lesser extent European equities (down around 4%).  By far the clearest winners have been commodities, notably gold (up 19%) and oil (up 13%). Returns in UK and US equities have been very modest (but positive) with emerging market equities more impressive at +6% or so.  What one needs to bear in mind in looking at such data is just how much these moves are merely corrections to some much broader, longer term trends.  Commodities, oil in particular, have had a very bad couple of years, and the rally here and in emerging market equities looks very modest against last year’s losses (oil was down almost 40% and EM equities returned -17%), with both benefiting this year from a resurgence in the value of the US dollar.  Of those asset classes which have done poorly in the  year-to-date, Japanese equities have eroded all of last year’s positive returns as the market has seemingly lost faith in the scope for Abenomics to continue to provide support.  One area that has continued apace, following a number of years of stellar outperformance, has been European Credit (corporate bonds), where investors have not only been chasing yield (with much of the European government bond market providing negative yields) but have also been loading-up on inventory ahead of a buying programme from the ECB, this being the next stage of European quantitative easing.

In looking at the flows into, and out of, asset classes, we can get some of the clearest indications from looking at the cash moving in Exchange Traded Products (ETPs).  These flows clearly only capture a part of what is going on, but one can argue that they come from those who are looking across asset classes on a relative basis, rather than those who are constrained to one asset class (such as central banks having to buy government bonds).  Data from fund manager Blackrock shows that, in 2015, money flowing into European equities far exceeded that going into European credit ($80bn vs $7.5bn), but that this year money has been moving out of equities (-$15bn ytd) and into credit (+$3bn).  With the credit markets being well supported by prospective ECB buying,  and the uncertainty of the UK Brexit vote and a Spanish general election providing a lot of uncertainty for equities, there would seem to be a likelihood of a continuation of these flows as investors avoid volatile asset classes.

The flows surrounding US equities may be still more telling.  Over the 2 years from March 2014, some $250bn flowed into US equities, far exceeding money going into any other equity or credit market (flows from EM equities were negative over the period).  Year to date the picture looks the same, with $14 billion having gone into US equities, but when looks at the flows in May, as people started to de-risk ahead of the US election, we get a different story. $14 billion was taken from US equities (ie the year’s inflow which would otherwise have been$28 billion has been halved), with much of the money seeming to go into the safe part of fixed income markets.  The only area of fixed income to really suffer in terms of flows was high yield credit (which saw outflows of over $4 billion), again seemingly due to a growing risk aversion.

The American Association of Individual Investors survey showed that 20% were optimistic about the US stock market, which is around half the historical average.  If one looks outside of just ETPs, data from EPFR (to the middle of May) showed that $90 billion had been taken out of global stock funds over the course of this year.  Given that we are a long way from the denouement in the current US political cycle, and given just how much money went into US equities, it would not be surprising to see this trend in the flow of funds developing further.  The activities of the Fed, or more importantly the market’s views as to when the Fed will act, will also have a bearing.  Last Friday’s US employment data may have delayed a near-term interest rate rise, but this just seems to be a delay in the inevitable,  as Janet Yellen has been at pains to point out this week.  Within the S&P 500 it is notably the defensive sectors that have outperformed, with utilities up 15% and telecoms 11.5% so far this year.  Analysis of flows in the options market is also quite telling, with more investors looking to buy some downside protection.

Overall, recent investment flows (at least those in ETPs) are pointing to an ever increasing risk aversion, and with such an uncertain global environment it seems unlikely that they will be reversed in the near-term.  For now that means we are likely to see periods of extreme short-term volatility, as we negotiate each key event, but also that riskier asset classes are likely to see ongoing outflows and hence some underperformance.  On balance it seems that to follow the cash, and “let the trend be your friend”, makes some sense.  At the very least it is worth having some capacity to buy, should equity markets have a sharp sell-off, and for the investments that we retain, a focus on low volatility defensive sectors seems most appealing.


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