The Great Rotation hasn't even started yet
by Raul Elizalde - 2013-07-25
A number of recent news reports give the impression that investors are switching out of bonds and into stocks in a large scale, after years of shunning equities and loading up on fixed income. But this “Great Rotation” of assets is not happening yet. All that the actual numbers show is that investors are taking a timid step out of the safety of bond shores into equity waters. This incipient migration from one asset class to another is still fragile, and can easily grind to a halt at the first sign of trouble. Conversely, it still leaves ample room for further demand for equities and consequently large price gains.
In the years after the financial crisis, investors showed a clear preference for bonds. They bought a lot of them, despite the best efforts of investment pundits who insisted that it was irrational to buy 10-year US Treasury bonds offering rates lower than inflation. But investors fully ignored this advice and bought bonds anyway, with great results: as rates declined, they realized huge capital gains. The price of a 10-year US Treasury bond goes up about 9% when its yield declines by 1%; a 30-year US Treasury climbs about 19% in similar circumstances. Who cares about inflation over the next 10 or 30 years if you can make those kinds of gains? So investors jumped on the Fed’s bandwagon and bought bonds too.
But recently interest rates have gone up, causing losses and making bonds unappealing. The higher rates are an inevitable consequence of the Fed’s clear indication that it will bring bond purchases to an end as the economy improves. This is the Fed's “exit strategy” after massively increasing the size of its balance sheet, and will cause higher interest rates not only because it will no longer be in the market for bonds, but because it may also start selling them. Indeed, the yield of 10- and 30-year US Treasury bonds has gone up by almost 100 basis points – or 1% – since the Fed first made its intentions known.
So if the Fed is no longer willing to buy bonds, it is natural for investors to anticipate the event and sell them in advance. In response to this, the largest bond managers like PIMCO have this advice for investors: stay the course and don’t sell your bonds. Investors are seeing through such self-serving advice and are selling anyway. But they are not stampeding yet.
Data from the Investment Company Institute, which tallies mutual fund flows, and from IndexUniverse LLC, which aggregates exchange-traded fund (ETF) flows, show that investors have redeemed the bond ETFs and mutual funds they purchased since the beginning of 2013. This liquidation, however, is small compared to the half a trillion dollars of bond funds they purchased since December 2010.
Likewise, investors have bought about $70bn of US equities so far this year, but are still running a $130bn deficit since the end of 2010. Non-US equities have been a more attractive destination in the last two and a half years, but whatever amount investors purchased still pales in comparison to the amount of money they directed to bonds.
So evidence that a “Great Rotation” is underway is feeble. In the context of the last couple of years, the recent bond sales have been sudden, but small. Whether they will become larger soon is far from certain.
Conditions for the US economy seem to be heading in the positive direction set by the Fed Chairman for ending bond purchases. But investors may have jumped the gun by selling so quickly. The last few economic releases show softer conditions, and, most importantly, inflation estimates continue to run below target.
Retail sales, housing starts, regional manufacturing indices, durable goods outside transportation, jobless claims and other indicators have come out somewhat worse than expectations in the last week or so. And the index of personal consumption expenses outside food and gas – core PCE, the main gauge used by the Fed – is only at 1.1% in the last 12 months, well below the 2% Fed target.
If the economy hits a soft patch and inflation expectations continue to go down, it is possible that the Fed may choose to delay the end of its bond purchases. This could lead to a surge in bond prices that can stop bond fund redemptions in their tracks. And while the common wisdom is that extending stimulus is good for stocks, the fact is that stocks have gone up because of a unique combination of monetary stimulus and improving economic prospects. Any suggestion that the Fed will continue to prop the economy longer than anticipated because it is deteriorating or inching closer to deflation may not be beneficial to stocks.
So news of the “Great Rotation” may be greatly exaggerated, or at least premature. While investors don’t seem to find anything left to squeeze out of bonds at the moment, conditions are still fragile and can easily revert along with expectations. That bond prices can go back up and stocks down in the short term is not out of the question.
On the other hand, the amount of money that can potentially be deployed to stocks is very large, and barring a significant worsening of conditions, we believe that it is only a matter of time for rates to rise to much higher levels. Despite temporary soft patches, the US economy is quite clearly improving, and Western Europe is not only inching back to growth but also revising its crippling austerity dogma. Once the Great Rotation really starts – and we don’t believe it has started yet – the long term upside for stocks can be truly significant. The long term for bonds, on the other hand, looks poor. The short term for both is another story.
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