15th February 2013
Those talking about the great rotation from bonds to equities are missing some very important facts according to Jeffrey Rosenberg, Chief Investment Strategist for Fixed Income at BlackRock.
He says that although the chatter about the move from bonds to stocks is heating up, it is missing one very important fact that the flow of US money is not out of bonds but out of cash and into equities. Below Rosenberg discusses what is really happening, how a great rotation might occur, some of the alternative scenarios and what they are advising fixed interest investors.
The “Other” Great Rotation – with bonds posting negative returns in January and equities posting significant inflows to start the year, the “Great Rotation” chatter from bonds to stocks heats up. Missing from this discussion, however, are the facts: both bonds and stocks posted inflows in January. Not out of bonds—rather, the rotation to equities came from cash. Having significantly built up cash allocations in response to the confidence-sapping fiscal cliff drama, its resolution appears to have led these monies back into equities.
Flows follow returns – presumptive in the “rotation” view is a stock market rise fueled by a return of asset allocation flows into equities missing since the onset of the 2008 credit crisis. Unfortunately the flows follow the returns. January’s negative bond returns coupled with strongly positive returns for stocks suggests that if sustained such “Great Rotation” may eventually show up.
Putting it in perspective – while the rotational arguments – whether from cash or bonds into stocks – dominates the typical US investor portfolio, it is important to put those considerations into perspective: US investors directly, or indirectly through funds/401ks, own only 18% of the US taxable fixed income market, leaving the majority of ownership outside of the “Great Rotation” debate. For municipal bonds however, individuals dominate so any “rotation” will be of much greater importance.
The “Other” Great Rotation
The “Great Rotation” story begins with the devastating impact of September 2008 and roughly 40% decline in equity portfolios for the year. Measured since 2007, bonds saw a cumulative inflow of nearly $1 trillion while developed market equities saw roughly $400bn of outflows (and $460bn of outflows when measured from 2008). Note that we split the equity category between developed and emerging, as another “Great Rotation” theme in equity investing post-crisis has been the shift into emerging market equities, registering $140bn of inflows since 2007.
Missing from this discussion, however, is the “other” great rotation. In the panic following the 2008 collapse, investors initially flocked to cash. Money fund assets provide one measure for tracking the amount of cash in investor portfolios. Figure 2 highlights these flows (see attached).
“Near the end of 2012, the trend towards reduced cash holdings reversed abruptly due to the post-election fiscal cliff-induced uncertainty. Investors increased their cash holdings to the tune of $150bn in money market funds and another $200bn in deposits over November and December. For money funds, this return completely reversed the year–to-date outflow from money funds witnessed through the end of October. With these flows in money funds and deposits as background, Figure 3 on the next page highlights the trend in retail flows in January showing both inflows to bonds and stocks.”
“Rather than a rotation between these two asset classes, stocks appear to benefit from a rotation out of cash as money fund holdings have declined by $21bn from their peak in January while commercial bank deposits have declined by $141 bn.”
Flows follow returns
“Presumptive in the “rotation” view is a stock market rise fueled by a return of asset allocation flows into equities missing since the onset of the 2008 credit crisis. Unfortunately the flows follow the returns. January’s negative bond returns coupled with strongly positive returns for stocks suggests that if sustained such “Great Rotation” may eventually show up.”
“Flow trends in January reflected movements into stocks from cash, while allocations to bonds actually increased, hardly indicative of the “Great Rotation.” And consider an entirely different “rotation” possibility: having now recovered stock market losses from the 2008 crisis, rising equity prices lead these investors to sell their equities as they look to lock in their gains and de-risk their portfolios in retirement. The flows haven’t followed the returns in recent years to equities as fixed income returns have kept pace. But as January’s returns highlight, and as our forecast for only 1-2 per cent returns in 2013 suggest, this year may begin to shift that calculation as returns to fixed income lag those of equities leading to eventual realization of such a rotation from bonds to equities.”
So what to do with my money now?
“The concern implicit in the “Great Rotation” theme lies in the manner of the move: a gradual smooth transition likely leads to little market dislocation while an abrupt move, exacerbated by a lower degree of fixed income market liquidity in a postcrisis, post-regulatory reform fixed income marketplace, leads to heightened market volatility and the potential for even greater market dislocation.
“Our advice remains to prepare the fixed income portfolio for the prospect of gradually rising interest rates in 2013 as we laid out in our January 2013 outlook issue: reduce interest rate risk through lowering duration exposure, making up for lost yield in select areas of credit risk-exposed fixed income sectors. Even in that latter recommendation we further recommend overall diversified exposures and tactically this month we pare back high yield.”