Asset-Class Fund Flows
Asset-class fund flow information is unique as it is one the few pieces of research information in the market that shows where investors are allocating or removing real dollars. Meaningful shifts in this data can at times signal changes in market dynamics or investor sentiment towards a specific asset class. Upon reviewing this monthly data from the beginning of 2022 through July of this year (chart below), we believe the clear takeaway is the shift in flows within the bond market. After 11 months of outflows in 2022, bond funds have had 7 straight months of inflows in 2023. These inflows are likely driven by falling inflation and the market’s belief that the Federal Reserve is nearing the end of their interest rate increases for this hiking cycle.
Importantly, we also note that the amount of total assets in money market funds (cash) is also approaching a 15-year high at roughly $5.5T in assets, driven by a 5.25% Fed funds target rate (chart below). The increased level of assets in these funds is likely due to 1) conservative equity marketing positioning, 2) increased investor allocation from longer-duration bond funds or 3) increased investor allocation from bank savings accounts. Time will tell how long investors stick to this positioning or if money in these funds will shift to fuel a market rally when the Fed begins to cut interest rates.
Lessons from the 1970s
Following the steepest interest rate hiking cycle in US history, US inflation has continued to decline from a peak of 9.1% in June 2022 to 3.0% in July of 2023. Now that inflation has declined, Fed chairman Jay Powell has the challenge of keeping monetary policy tight to continue to fight inflation, without pushing the US into recession.
Lessons relating to this balancing act can be learned from the 1970s. Following a period of high inflation, Fed chairman at the time – Arthur Burns – appropriately hiked interest rates in the early 70s. The US economy slowed significantly which led to a recession in 1974, with unemployment rising from 5% to 9%. Following increased pressure by economists and administration officials, Burns prematurely loosened monetary policy by cutting interest rates. This short-sighted pivot caused prices and inflation to re-accelerate through the late-70s. This wavering approach later became known as stop-and-go Fed policy and is viewed by historical accounts as a tough time period for the Fed. It was not until the early 80s when newly elected Fed chairman Paul Volcker significantly hiked interest rates again and maintained restrictive policy for an extended period of time that inflation was finally brought back down to a more sustainable level.
When history books are written, current Fed chairman Jay Powell does not want to be the next Arthur Burns. He will likely use aspects of the 1970s as a guide when fighting inflation in 2023 and leave rates higher for longer rather than change course too soon and risk inflation re-accelerating.
The excitement surrounding artificial intelligence (AI) has contributed to much of the market rally to start 2023, with significant outperformance in handful of stocks in the technology sector (please see our blog post highlighting recent market leadership here: https://www.vlpfa.com/blog/the-vlp-live-greater-view-the-magnificent-seven ).
The number of S&P 500 companies citing “AI” on earnings calls increased significantly in 1Q23 to 110 – this number is well above the 5-year average of 57 and 10-year average of 34 (chart below). While the productivity benefits, uses and investment case of AI are clear, much of the near-term anticipation surrounding AI has likely been baked into stock prices at this point through multiple expansion. These companies will now need to show increased earnings power as a result of this technology to continue to move their stocks higher.
Outperformance by the technology sector on the back of AI has driven large-cap stocks to significantly outperform small-cap stocks in 2023. Large-cap stocks (as represented by the S&P 500 Index) are now approximately 7% from their all-time highs made on 01/04/2022, while small-cap stocks (as represented by the Russell 2000 Index) are still 26% off their all-time highs made on 11/08/2021. This set up leaves the potential for the broader market (as represented by small-caps) to catch up to large-caps and emphasizes the reason to remain diversified as we move into the second half of 2023.
If you are not confident in your portfolio positioning or would like us to review your current approach to investing, please reach out to us! Conveniently schedule time with one of our advisors here: https://www.vlpfa.com/schedule-a-meeting
Disclosure: Investment in mutual funds is subject to risk and loss of principal. There is no assurance or certainty that any investment strategy will be successful in meeting its objectives. Investors should consider the investment objectives, risks and charges and expenses of the funds carefully before investing. The prospectus contains this and other information about the funds. Contact our office at 8391 Old Courthouse Rd. Ste. 203 Vienna, VA 22182 or (703) 356-4360 to obtain a prospectus, which should be read carefully before investing or sending money.
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.