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Investors lean on fixed income as risk appetite dips towards neutrality

By Jessica Penny
3 minute read

The most recent State Street Risk Appetite Index reflects a challenging month for bonds and equities, described as “frightful”, yet investor responses have defied initial expectations.

The index fell to 0.0 in April from 0.09, indicating a modest retreat by investors towards a more neutral risk bias.

According to Michael Metcalfe, head of macro strategy at State Street Global Markets, this was led by a surge in demand for the US dollar, with inflows close to a five-year high over the month.

“The flip side of this is that institutional investor flows into the Japanese yen (JPY) and emerging markets currencies weakened. Even before the JPY volatility at the end of April, we note that long-term investor holdings of the JPY were already close to neutral,” Metcalfe said.

Meanwhile, risk appetite appeared to be more mixed across equities, with weaker demand stemming from high beta stocks, including tech, offset by stronger demand for emerging markets, including China.

State Street also revealed that, as a whole, investors returned to fixed income over April. However, Metcalfe noted that this was most concentrated in Treasuries, with minimal taste for riskier emerging market debt or high yielding corporate credit.

Notably, cash holdings returned to their long-run average over the month, leaving fixed income holdings as the “prime beneficiary”. Namely, allocations rose 0.4 percentage points to 27.9 per cent, the biggest monthly rise in fixed income allocations since March 2023.

“April was a frightful month for bond and equity market returns, but the reaction of institutional investors was telling,” Metcalfe said.

“Rather than hide out in cash, they increased their allocation to fixed income by the most in more than a year. A prescient move given the high, not higher, for longer message on rates from the Fed at the beginning of May and perhaps the beginning of investors reassessing their still significant underweight in bonds.”

While the unlikely prospect of a US interest rate rise is encouraging, Metcalfe expressed concern over allocations to cash reverting to their long-run average. This trend suggests that any “excess” cash previously held on the sidelines may now be exhausted.

“Given equity holdings are still close to a 15-year high, the bar for good news to pull more money into equities has now been raised as investors would likely need to fund this with an ‘underweight’ in cash.

“In contrast, if US interest rates really are going to be high and stable for now, investors may begin to reassess their significant underweight in fixed income and look to have begun doing this in April,” he said.

Moreover, State Street Holdings’ indicators, which track the allocation of investor portfolios across equities, fixed income, and cash, revealed a decline in long-term allocations to equities and cash by 0.2 per cent points each, now standing at 53.3 per cent and 18.7 per cent, respectively.