The ECB Outlook 2011 : US mutual funds flows and Supply Outlook 2011

US mutual funds flows

The recent crisis has proved a market changer for the mutual fund industry. The financial crisis, its impact on the real economy and the growing likelihood of a double dip scenario has progressively heightened investors’ sensitivity to risk. During the last couple of years, the main market trends have been strongly correlated with the wide swings in risk aversion, which became a key driver in several markets. The response to market tensions has been an increasing flight to quality (or safety).

The US has the largest mutual fund market, which corresponds to slightly less than half of the total assets invested in the industry worldwide. We looked at the main trends on US mutual funds to gauge how changes in their allocation could affect the future performance of financial markets.

The total flows into US mutual funds were a negative USD 150bn in 2009, the first negative figure since 2003. This year, outflows from the US mutual fund industry should continue, as redemptions from money market and equity funds outweigh the positive flows to bond funds. YTD (until mid-November), equity funds faced outflows  of USD 32bn, money market funds faced outflows  of USD 540bn while bonds faced inflows of USD 270bn.

Net inflows to equity funds have been historically strongly correlated to the performance of stock indices. However, the strong rally that kicked in after March 2009 did not lead to a stable increase in risk appetite nor to significant positive flows into equity funds. Indeed, until mid-November equity funds saw USD 32bn in outflows. Moreover, most of the withdrawals came from funds investing in domestic (US) equities. However, the last few weeks (covering the month of October) have shown a decrease in the size of redemptions and
signal that this trend might have gained momentum in November.

Bond funds benefited from the demand for safe assets during the last two years. In 2009 net inflows into bond mutual funds reached a record level of USD 376bn. Until midNovember, US bond funds raised USD 270bn, lower than in 2009, but still positive.
In a market strongly biased  towards safety, Fed monetary easing in 2008 and its two rounds of QE have most likely contributed to keep demand for fixed income assets high. Moreover, broad total return indices for this asset class show that in the 2009 and 2010 bonds posted a positive performance, the highest since 2003. This is a factor that has most likely provided support to demand for bonds.

Money market funds were the main determinant to the overall outflow from US mutual  funds, contributing with net outflows of more than USD 1tn during the last two years. After having peaked in 1Q 2009, when they reached a total asset value of USD 3.92tn (the highest level ever), money market funds saw large withdrawals in late 2009 and 2010. Very low rates and the expectations that the Fed would remain on hold for a prolonged period decreased the appeal of money market instruments. Indeed, while flight to quality has
certainly contributed to increased demand for liquidity, investors probably are not willing to accept nearly zero returns for a long time.

US mutual funds are an important source of demand for financial markets: with a total invested amount of more than USD 10tn, they certainly have a sizeable impact on market trends. Therefore, hints on the flows to US funds are a key factor for future market trends.

Net inflows into these funds will probably keep on being strongly dependent on risk aversion. Only once the US economy will resume growing more convincingly will investors start shifting sizably their allocation from bonds into equities. According to our economists' forecasts, this may happen in the second half of 2011.

Redemptions in money market funds will likely continue, as the Fed will keep its official rate at a very low level. . It is unlikely that we will see money markets rates reaching interesting levels during 2011. An increase in flows to these funds could emerge in case the economic outlook deteriorates significantly, spurring demand for liquidity, which is not our baseline scenario.

Overall, the current trends we observe in flows in and out of US mutual funds shouldstay in place for the first half of 2011. Given the historically low levels of bond yields, once investors start seeing signals  that the economy is improving, they will rebalance their portfolios quickly, contributing to accelerate the speed of the bond sell-off.  Equity funds would benefit from such a turn. Equity funds that invest in foreign stocks represent about one fourth of equity funds, and their contribution will be relevant as soon as the global economic recovery improves.

Bottom line  Overall, while money market rates driven by expectations of monetary policy will remain at
historically low levels, the trend in mutual funds should further fuel a rise in bond yields in the second half of 2011, when we expect that  the US economy will start showing a more substantial improvement. The increased   optimism should be beneficial for equities.

2011 redemptions up EUR 45bn vs. 2010 

In 2011, domestic bond redemptions in the EMU will be EUR 555bn, some EUR 45bn higher than in 2010. Interestingly, after experiencing a decrease in 2010, redemptions will reach a new all-time high next year.

Furthermore, due to the last three years' massive supply in the EMU, especially at the short end, redemptions in 2012 will increase by further EUR 70bn, reaching EUR 630bn. With respect to 2013, current outstanding debt is EUR 485bn. We expect EMU countries to keep supply of bonds maturing in 2013 year relatively subdue. Hence redemptions should remain below EUR 630bn, albeit moderately.

An important factor to watch is that redemptions will continue to grow from 2011 to 2013, and some countries will face redemption walls in the next few years. Austria, for example will have EUR 22bn of redemptions  in 2014 (more than twice the average of 2011, 2012 and 2013). Spain will have a redemption peak in 2013 at EUR 55bn (plus debt to be issued next year with this maturity). Portugal will have a peak in 2014 at EUR 14bn. France will have very high redemptions both in 2012 and 2013 at EUR 125/130bn (but France is very active with buybacks). Redemptions in Germany will continue to grow until at least 2013 to
reach the EUR 155bn area. Italy will have EUR 185bn of redemptions in 2012.

The left chart below shows the change in the redemption profile by country next year vs. thisyear. Redemptions will increase in almost every EMU country, especially in France (+EUR 13bn), Germany (+EUR 13bn), Spain (+EUR12bn) and Greece (+EUR 11bn). Redemptions will be roughly unchanged in Belgium, Austria and Finland. Italy will be the only country which will enjoy a significant decrease in redemptions: - EUR 16bn. More specifically, the drop in redemptions will come from CCTs (-EUR 7bn) and
ILBs (-EUR 15.7bn). Redemptions of BTPs will be roughly unchanged and redemptions of CTZ will be EUR 7bn higher than this year.

Very much in line with last year, July and September will be the most liquid months of the year, with almost EUR 90bn of expiring bonds in each month. Redemptions in July will mainly come from Spain, Germany and the Netherlands, while in September they will mainly come from Italy, Belgium, Germany and France.

Unlike this year, January will be relatively less liquid than usual, with redemptions almost EUR 30bn lower than in 2010. March will be significantly more liquid than last year (+EUR 23bn) and the same holds true for October.

Coupon payments will amount to about EUR 195bn in 2011, EUR 15bn more than this year. Such an increase in coupon payments should continue to weigh over the next few years as well, as a result of the increased amount of debt caused by the crisis.
Full report: The ECB Outlook 2011 :  US mutual funds flows and Supply Outlook  2011