Demonstrators in Germany protest against rising energy prices
Investors are being spooked by ‘a deepening energy crisis’ in Europe © Reuters

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Investors pulled money from European equity exchange traded funds in August at the fastest pace since the 2016 Brexit referendum as fears of recession mounted.

The $7.7bn withdrawn from the sector was the sixth straight month of net outflows, and second only to the $8.9bn of net selling recorded in July 2016, according to data from BlackRock, reflecting the darkening sentiment across the continent.

Amid war and surging inflation, investors were being spooked by “a deepening energy crisis”, said Karim Chedid, head of investment strategy for BlackRock’s iShares arm in the Emea region. This was allied to “hawkish repricing” of European Central Bank policy “throughout August, especially at the front end [of the curve],” he added, with markets now pricing in a 50 per cent likelihood of a 75 basis point rate rise, rather than 50bp, at the bank’s coming meeting on September 8.  

“The yield curve shows [the market] is expecting a recession,” said Kenneth Lamont, senior fund analyst for passive strategies at Morningstar. “Clearly there is risk being taken off the table. The market is positioning itself for the storms ahead.”

Despite the grim economic backdrop, Chedid said he was surprised by August’s outflows, given that European equities were already “under-owned by investors, especially foreign investors”, according to BlackRock’s calculations.

Column chart of Monthly net flows ($bn) showing European equity ETFs

Detlef Glow, head of Emea research at Refinitiv Lipper, said European investors had moved from being underweight US equities in 2018 to being overweight now, attracted by stronger economic growth, lower energy prices and the tailwind of a rising dollar.

The exodus from European equities was more jarring still given that, globally, ETF flows pointed to a modest revival of risk-on sentiment in August.

Total global inflows ticked up by $2.5bn month-on-month to $49.4bn in August. The US stock market led the way, with net inflows jumping from $12.6bn in July to $30.2bn.

Chedid attributed the chasm in appetite for US and European equities to differences in the composition of the two equity markets, with Wall Street having a higher weighting of technology and healthcare stocks and factors such as “quality” — stocks with a high return on equity, stable earnings growth and low leverage — which is “what you want to own when margins are coming under pressure and inflation is high,” Chedid argued.

In contrast, Europe has a higher exposure to cheaper “value” stocks and sectors such as banks, energy and industrials.

And while earnings projections “look too high [and] have room to be downgraded”, in both the US and Europe, Chedid believed there was room for “a bigger downside surprise” in the latter, given the economic storm clouds.

In another tentative sign of recovering risk appetite, emerging market debt ETFs saw their first net inflows since January, even if the $1.4bn of buying reversed only a fraction of the cumulative $11.7bn of net outflows witnessed between February and July.

Lamont said the buying was geographically broad, with European-domiciled global emerging market bond funds seeing their biggest monthly inflow since 2013. This stood in contrast to earlier in the year, when investors were largely focused on the beneficiaries of higher energy prices, such as the Gulf states.

Column chart of Monthly net flows ($bn) showing Emerging market debt ETFs

Chedid attributed the renewed enthusiasm to valuations, which have become more attractive after this year’s sell off, allied to a view that emerging market central banks are typically ahead of developed markets in their rate-hiking cycle.  

Glow agreed, saying “investors are looking for diversification in their portfolios and they may have found that EM bonds are at better valuations”.

Nevertheless, Chedid cautioned that the bulk of the flows had gone into hard-currency bonds, the lower risk half of the EM debt spectrum, and that it may be “too soon to call it a turnaround”, given that developed world fixed income yields had risen, so “investors don’t have to go far in their search for income”.

Line chart of Cumulative flows, year-to-date ($bn) showing Financial sector ETFs

ETFs specialising in financial stocks may be at a turning point, however. After a painful run of outflows since March, they topped the sectoral sales chart in August with net inflows of $2.4bn, despite continued selling of European exposures.

Chedid attributed this to a combination of a strong second-quarter reporting season and the steepening of the US yield curve witnessed in August, potentially improving banks’ net interest margins.

Overall Glow argued the continuing inflows into ETFs, even as mutual funds have bled assets, demonstrated that “investors really favour ETFs in times of crisis”, as in 2008, 2011 and 2020, when they saw full-year inflows despite economic ructions.

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