FINSUM
According to the Index Industry Association’s annual ESG survey, 76% of respondents integrate ESG when running both passive and active fixed income mandates. This is a large jump from 42% in 2021. The survey, which was conducted with 300 asset managers, also found that 87% of passive asset managers are integrating ESG into their bond allocations. 85% of asset managers stated that ESG had become a higher priority over the past 12 months. Out of this figure, 43% said the concern around climate and corporate governance was the driving force behind that decision. Other reasons were a need for more diversified returns, regulatory and reputation risk, high energy prices, and geopolitical events. Almost a third cited a desire for increased returns. The biggest driver was their client’s knowledge of ESG, with 53% stating they were “very confident” in their clients' ESG knowledge.
Finsum: Asset managers are implementing ESG into fixed income allocations at a higher rate due to climate and corporate governance, diversified returns, higher energy prices, and client knowledge.
Research from Morningstar's annual Global Fund Flows found that actively managed fixed income funds saw $422 billion in outflows during the first half of the year. That figure accounted for 74% of all outflows from active portfolios. Active funds as a whole saw $568 billion in outflows, while index funds generated $432 billion in inflows. The net difference of $136 billion in outflows was the most since June to December of 2008, during the height of the Financial Crisis. The high percentage of active fixed income outflows is partly a result of the automatic rebalancing of model portfolios and target-date funds. Since equity returns have been more negative, automatic rebalancing has been triggering more trades to equity strategies to get allocations back in line. Passive fixed income funds saw $90 billion in inflows.
Finsum: Active fixed income funds accounted for 74% of all outflows from active portfolios during the first half of the year as automatic rebalancing favored equity strategies.
According to a paper published last month by Christopher Reilly of Boston College, corporate bond ETFs listed in the US, on average, pay 48 basis points a year in hidden costs that result from custom creation baskets. Since most fixed ETFs track thousands of individual bonds, custom creation baskets allow issuers and authorized participants to create a sample of the holdings which mirror the performance of the ETF. An authorized participant is an organization, typically a bank, that manages the creation and redemption of ETF shares in the primary market. Without sampling, the authorized participants would have to source every security. However, the custom ETF creation baskets allow authorized participants more flexibility to include securities that could significantly underperform the underlying index. This customization results in hidden costs that investors of ETFs could incur.
Finsum: Corporate bond ETFs are paying an average of 48 basis points a year in hidden costs resulting from customized creation baskets.
2022 has seen one of the most volatile six-month stresses that hasn’t included a full-blown economic collapse. With the U.S. recession looming, Fed tightening, surging inflation, and international conflict all still very much in play investors need a volatility strategy. Most investors’ loss aversion keeps them out of market gains and a negative bias, and a low volatility strategy can curb those fears while allowing participation. This is a factor-based approach to investment where a considerable factor can be on stocks with more stable price movements in comparison to the rest of the market. Typically this strategy favors older, medium to large companies, with stable performance. If markets take a large hit many of these bear less of the losses, but they still can capture the rallies during high volatility.
Finsum: A momentum factor strategy has the advantage in low-interest rate booms, but favoring stable price movements might beat markets in this environment.
The markets rally in response to the Fed’s latest tightening cycle, but it's the movement in combination with bonds that are potentially concerning. The longer end of the yield curve may not be realizing the extent of the Fed tightening with the 10-year rates falling in response. Analysts say this could be markets reading what they want from the Fed and not taking this phase of tightening seriously. This also could be the opposite, as the ten-two-year yield curve inverts, this could be the markets predicting a recession on the horizon, that is if the U.S. isn’t currently in one. Regardless, Powell made it completely clear that inflation is concern number one, and the Fed doesn’t believe the economy can function normally until inflation is tamed.
Finsum: There’s a possibility markets are happy there is a recession, because it could be the return to easy money and low rates.
Available in a gaggle of shapes and sizes, fixed income securities are a staple of investor portfolios, according to etf.com.
They’re loans, of course, from the public investors to an institution in the market for cash. The borrowers and investors issue the bonds. Naturally, the investors expect to be reimbursed and compensated for the ability to tap into their money and the risk they’re assuming in extending the loan, the site continued.
Often, that compensation or the interest on the loan, is a regularly paid coupon.
With net inflows of $910 billion into U.S.-listed ETFs, ETS had an unprecedented year in 2021, according to eftdb.com. That said, with the momentum taking a turn later in the year, ETFs experienced a spike in flows, which is expected to extend into this year – in the fixed income space particularly, stated Todd Rosenbluth, head of ETF and mutual fund research at CFRA.
Meantime, logic seemed to go somewhat out the window with U.S ETF flows through June in light of persistent hearty inflows given markets that were drastically toppling, according to insight.factset.com. Although stocks sagged nearly twice as much, stocks experienced healthier ETF inflows than bonds.
An active fixed income fund, which is an actively managed bond fund, socks money mainly in bonds, according to zurich.ie. They’re issued by eurozone governments and bond-based financial instruments. It doesn’t stop there, however. Additionally, they can be invested supranational bonds and other investment grade corporate and non-sovereign bonds.
Parachuting inflation has translated into tumultuous equity markets, prompting the Federal Reserve Board to hit the gas on interest rates, according to etftrends.com. Against that backdrop, the spotlight’s on both fixed income and active management.
This shouldn’t prompt even a raised eyebrow, based on data. When markets were most turbulent in 2020 and 2021 --- more so in fact than they’ve been inn decades – not even half of almost 3,000 active funds experienced superior performances over their average passive counterparts during the 12 months through June of last year, based on Morningstar data.
While passive equities strategies generally have gotten the best of active managers, active bond managers have returned the favor on passive fixed income strategies, according to a report from Guggenheim Investments.
More broadly, the average active large cap equity fund manager’s gotten the upper hand on the S&P 500 86% of the time over the past decade, the site continued.
With yields rising it may be time to start paying attention to muni bonds again. The double tax efficiency with tax-exempt bonds and efficient ETFs give an additional return edge. In addition to this, there is a flight to safer assets because of all the market volatility currently, and muni bonds provide that much-needed safety investors are looking for that high-yield corporate or emerging market debt can’t compete with. Vanguards Tax-Exeempt Bond ETF (VTEB) is one of the most popular Muni Bond ETFs, with over 4/5ths of its holdings in Federally tax-exempt bonds. Fidelity’s Tax-Free Bond Fund (FTBAX) offers similar objectives and also invests in using a leveraging technique that can amplify the returns or losses. BlackRock (BATEX) offers a fund with junk exposure, by investing up to 10% in distressed muni’s that could provide higher returns with more risk.
Finsum: Muni’s offer a competitive option to government debt, and with rising yields, they are beginning to look attractive.
Last week, BlackRock made a massive splash by introducing a new set of model portfolios targeted explicitly at female investors. This idea could just be the beginning in addressing specific targeted objectives for different investor demographics using model portfolios. BR set the portfolios to tune in the balance to better suit women’s objective outcomes, but this could be expanded beyond just female investors. For instance, the right mix of assets could be selected to suit those facing higher amounts of college debt or those with different lifestyle preferences. Model portfolios are the first investment class we have that is naturally oriented to solve these problems. There is a market for asset classes that can target different demographics and lifestyles all while making an advisor's job simpler.
Finsum: BR’s new set of models were an ingenious decision and better financial models can help people address their more specific financial needs.
By William Sterling, Ph.D. Global Strategist, GW&K Investment Management
The Outright Ugly
Let’s get the worst out of the way. Without question, inflation data in June was terrible. In fact, June was significantly worse than expected, with headline Consumer Price Index (CPI) and Producer Price Index (PPI) inflation running at 9.1% and 11.3% versus a year earlier, versus expectations of 8.8% and 10.7%, respectively
Headline CPI and PPI Inflation Continued to Shock in June Amid Evidence of Broad-Based Price Increases
Source: GW&K Investment Management, BLS, and Macrobond.
Core CPI was also worse than expected at 0.7% m/m versus 0.5% expected and 0.6% previous. The only hint of moderation was in core PPI, which gained 0.4% m/m versus 0.5% expected and (downward revised) 0.4% previous.
The Bad
Consensus forecasts for the world economy in 2022 have changed dramatically. Despite upbeat June jobs and retail sales reports, economists slashed 2Q GDP estimates in recent days, with Bloomberg’s consensus median for 2Q moving from 3.0% on July 14 to only 0.9% currently.
Bloomberg Survey of Economists Now Projects “Stall Speed” 2Q Growth of Only 0.9%
Source: GW&K Investment Management and Macrobond.
Over the same period, projected 2022 4Q y/y growth estimate went down from 1.4% to 0.8%. These numbers indicate a “stall speed” growth, which suggests that economists see coin-flip odds of a recession ahead (per Bloomberg survey). Bloomberg’s results are also echoed in data from the Federal Reserve Bank of Atlanta.
The Atlanta Fed’s tracker puts Q2 GDP growth at -1.5% following a -1.6% contraction in Q1. That would meet the unofficial definition of a recession as two consecutive negative GDP quarters. But it would not meet the “official” NBER definition, which defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale and retail sales.”
The fallout from the war in Ukraine on energy prices, hawkish central banks, and prolonged lockdowns from China’s Zero-COVID policy have also been major drivers of the forecast revisions.
The Good
If there is a silver lining to be found, it is that after being large net debtors for several decades, American households overall have developed “fortress balance sheets” during the pandemic. Liquid assets (by our definition*) now exceed total debt for the first time in three decades. While rate increases will likely continue to rise and slow the economy, the good news is that households may be net beneficiaries of rising short-term interest rates if they start earning serious interest income on their $17.9 trillion in liquid assets.
U.S. Household Liquid Assets Exceed Debt for the First Time in Three Decades
Note: Liquid assets are defined as the sum of currency and checkable deposits, money markets fund shares, time deposits, and short-term investments.
Source: GW&K Investment Management, Federal Reserve, and Macrobond.
Elevated Inflation is Boosting Retail Sales: Nominal vs Real Retail Sales
Source: GW&K Investment Management and Macrobond.
Further, while inflation has clearly eroded consumers’ spending power, American households are spending more even if they are enjoying it less. In June, retail sales jumped 1.0% m/m versus 0.9% expected and a (revised upward) -0.1% decline in May. This was a new record for retail sales in dollar terms, up 29% from February 2020. That said, deflated by the CPI component for goods, the real value of retail sales peaked in March 2021 at 15% above its February 2020 level.
Where Do We Go From Here?
Inflation remains top of mind for everyone, but perhaps even more so at the Federal Reserve. If the Fed increases rates by 175 bps by November 2nd (as is widely expected), the 3m-10y and 3m-2y yield curves will invert by about 25 bps and 45 bps respectively. Unless the Fed pauses soon, recession odds will rise substantially. The cautious optimism on inflation that we saw back in April has dissipated and the call for tighter monetary policy and slower growth to curb inflationary pressures has left no room for complacency at the Federal Reserve.