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Investors pull out of European stocks in record outflow streak, pile into bonds

Statues of a bear and a bull stand outside the Frankfurt Stock Exchange.
Hannelore Foerster | Bloomberg | Getty Images
Statues of a bear and a bull stand outside the Frankfurt Stock Exchange.

Positioning in this year's popular trades is building.

Investors prefer bonds over stocks, and European equities are well out of favor, according to the latest fund flow data.

European equities posted a record 29 straight weeks of outflows with a drawdown of $2.0 billion, according to EPFR Global data cited by Bank of America Merrill Lynch in a Thursday report. Meanwhile, investors poured $6.6 billion into bonds, marking the 19th week out of the past 21 weeks of inflows, the data showed.

Thomson Reuters Lipper data also showed U.S.-based taxable bond funds attracted $2.7 billion for their third straight week of inflows, while U.S.-based stock funds reversed their first inflows in five weeks with an outflow of $6.4 billion in the week ended Aug. 24.

"For the near term at least, you're in a situation where yields are going to go lower and valuations will continue to be stretched," said Craig Bishop, lead strategist, U.S. Fixed Income Strategies Group at RBC Wealth Management. He noted the U.S. Federal Reserve is not likely to raise rates until next year, keeping rates low.

This year, globally accommodative policy has sent benchmark bond yields to historic lows, including negative territory. The chase for yield and relatively better U.S. economic growth have also sent U.S. stocks to record highs.

"I think people are still looking at the absolute yield of the U.S. versus the rest of the world without taking in the impact of the rising inflation we're going to see in a few months," said Bryce Doty, senior fixed income manager with Sit Investment Associates. "We're probably going to see decent flows into bonds."

In other developed markets, Japanese stocks have come under pressure from the strong yen, despite the Bank of Japan's stimulus efforts, and post-Brexit uncertainty has weighed on European equities.

BlackRock is underweight European equities and neutral U.S. and Japanese stocks.

However, with such heavy positioning, investors could find themselves on the wrong side of the trade if trends reverse. Inflation is showing signs of picking up, and the U.S. Federal Reserve is still on pace to raise, not lower, rates. Analysts also note that market momentum is pushing overseas yields further into negative territory and a turnaround in sentiment would likely cause a sharp drop in price.

"That's a concern, something investors need to be aware of. … I think it'll be up to central banks to manage that process as we go forward to prevent that kind of environment, such as the taper tantrum as we saw in 2013," Bishop said.

When the U.S. Federal Reserve indicated in mid-2013 it would wind down its monthly bond purchases, or quantitative easing, stocks dropped and yields rose.

Euphoric fund flows to assets tied to 'zero-rate' expectations

Source: BofAML Global Investment Strategy, EPFR Global

Friday's market action also highlighted markets' sensitivity to central bank policy. Fed Chair Janet Yellen indicated in her highly anticipated Friday speech that the case for raising interest rates has strengthened recently. Markets initially took a slightly hawkish read on her comments, before finding little reason to increase expectations that a hike would come sooner rather than later.

However, within the next two hours afterward, Fed Vice Chair Stanley Fischer said on CNBC that the U.S. economy is stronger and the decision on whether to raise rates should be looking forward at data, including the jobs report due next week. Employment has been one of the strongest areas of recent economic reports.

"He has a more rational common sense description of where the economy is at and did a nice job dispelling the idea that central banks are becoming less worried about inflation," Doty said in an email. "Consequently, his comments reduced some of the 'cushion' that markets were feeling they had before needing to worry about another rate hike."