Photo: flickr / Doug Wertman
The big theme of 2013 – according to investment strategists at shops across Wall Street – will be the “Great Rotation,” a massive move out of bonds and into stocks.Economic growth in the U.S. is expected to accelerate, facilitating the shift.
Hedge fund manager Ray Dalio agrees – in an interview with CNBC this morning, he characterised 2013 as a transition year in which large amounts of cash that have been tied up in bank accounts or hidden under mattresses will move into equities and other risk assets.
Sure enough, we’ve seen historic fund flows into equity funds already in 2013 – but surprisingly, bond funds haven’t seen big outflows.
For a while now, BofA Merrill Lynch Chief Investment Strategist Michael Hartnett has been out in front of the rest touting the “Great Rotation” theme for 2013 – and he says it’s already begun.
Even though the public data don’t show investors shifting out of bonds and into stocks yet, Hartnett says BofA’s data on client position does show exactly that.
In a new note, Hartnett writes (emphasis added):
The past seven years have seen a Great Divergence in terms of fund flows. Investors have poured $800bn into bond funds and redeemed $600bn from long- only equity funds. But recent data show the first genuine signs of equity-belief in years. The past 13 days have seen $35 billion come back into equity funds ($19 billion of which is via long-only).
And while the industry flow data does not show “rotation” out of bonds, our private client data does. The structural long position in fixed income is simply threatened by low expected returns thanks to low rates and the mathematical reality that a small rise in rates can cause total return losses in portfolios. Table 1 shows that negative returns would occur if the 30-year Treasury yield rose from 3.03% to above 3.26% anytime in the next 12 months (and note the same yield was 4.53% just 3-years ago).
However, there are still two big risks to an “orderly” rotation out of bonds and into stocks this year, in Hartnett’s view. He says the possibilities of either a “1994 scenario” or a “1987 scenario” jeopardize a smooth transition:
The current level of US jobless claims (335K) is the lowest since Jan 2008, when the unemployment rate was just 5.0%. If the global economy and corporate animal spirits revive sufficiently to cause an upward surprise to US payroll numbers in coming months, say numbers in excess of 300K, then a repeat of the 1994 “bond shock” is likely. In recent months we’ve drawn a number of comparisons to market returns in 2012 and 1993, the last year banks assumed major global leadership. In 1994 the combination of stronger-than-expected payroll, a tighter Fed, a 200bps back-up in yields led to a big pause in the nascent equity bull market and a savage reversal of fortune in leveraged areas of the fixed income markets (e.g. Orange County & Mexico). Investors banking on economic recovery should therefore be reducing longs positions in High Yield and EM debt.
In contrast, in 1987, rising risk appetites caused equity prices to drag bond yields higher. At the same time, policy tensions over currency valuations between Germany and the US also put upward pressure on bond yields, as well as gold prices. Ultimately the combination of policy risks, rising gold and bond yields helped precipitate the October crash in equity markets. A repeat of 1987 is a low probability event in 2013. But it is also clear that risk appetite is on the rise, many countries are trying to devalue their way to growth, risking a currency war, and should gold start to respond favourably to this backdrop, we would certainly worry that a major risk correction is imminent.
So, what does this mean for investors? Hartnett writes that given the recent surge in investor sentiment (click here for eight indicators that illustrate this pretty clearly), a correction in the stock market in the next month or so would be a good thing.
However, if we don’t get a correction in the next month or so. Here’s why, according to Hartnett:
Retail inflows into equity markets have started to pick up (more inflows are expected to be reported in the weekly numbers) and individual investors are still lightly positioned in equities relative to history.
Further, both the EPS and GDP “bars” are low in early 2013. The three-month suspension of the US debt ceiling renders DC uneventful in the near term. And it is too early to argue the policy is not working to stimulate growth. Q2 is crucial in this respect.
If all of these factors come together to prevent a pullback in stocks this winter, Hartnett worries that “a combo of excess risk positioning and liquidity withdrawal could lead to a bigger correction in Spring.”