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The ditching of government bonds in favour of shares has seen stock markets continue to rise, but experts are warning investors not to get too bullish about the ‘great rotation’.Investors love a story. Look behind every persistent investment theme and you will find a compelling narrative – and usually a catchy slogan to go with it. So the “cult of the equity” marked the generational shift from bonds to equities in the Fifties, “TMT” became shorthand 15 years ago for investing in the so-called new economy and, in the week in which Jim O’Neill has left Goldman Sachs, we should not forget the “Brics”, which became synonymous with emerging market investing.
The latest addition to this list is the “great rotation”. As with its predecessors, it has gained currency because it contains a germ of truth. Like the others, its significance is in danger of being overstated because of the ease with which it rolls off the tongue.
The case for a rotation out of bonds and into equities is not hard to make. After a 30-year bull market, government bonds have risen to prices at which the income they offer investors no longer compensates them for the risks they take by holding them, nor in many cases even offsets the erosion of purchasing power caused by inflation. As Professor Paul Marsh of the London Business School said this week, “to extrapolate the high bond returns of the past 30 years into the future would be fantasy”. As is the nature of bull markets, most of the money has flowed into the asset class in its latter stages, when the potential returns are least attractive.
By contrast, equities have endured a 13-year bear market since the bursting of the dot.com bubble. As a consequence, they now offer investors a compelling investment case, with valuations at relatively low levels compared with the past 25 years and an inflation-beating income (with the potential for growth as an added bonus when compared with fixed-income bonds).
After more than a decade of volatile returns, including two periods in which prices have halved, investors remain to be convinced by the case for investing in shares. This natural reticence has been compounded in the case of many institutional investors such as pensions funds by regulations demanding they hold less “risky” investments. This has led to UK pension funds holding as many bonds as equities for the first time in decades.
There is some evidence these factors are beginning to influence investor behaviour. The monthly statistics from the Investment Management Association, for example, show that retail investors favoured equity funds over bonds in each of the four months between September and December last year. In the first eight months of 2012, they had shown a preference for bonds, by a wide margin in some cases.
But the evidence is not wholly convincing that this represents the early stages of a great rotation. For one thing, the flows into bond funds remain positive, so the preference for equities could just as easily be attributed to a simple increase in appetite for investments of all kinds as sentiment improves.
Fund-flow data from the US suggests the source of the money which has given Wall Street its strongest start to the year for more than a decade (more than 20 years in London) is actually money market and other cash funds and not bonds at all.
It is the reinvestment of the many dividends paid out in December to beat feared fiscal cliff-related tax rises which has driven markets to a five-year high.
This is not to dismiss the great rotation thesis. Equities look the more attractive asset class today and over time I would expect a rebalancing between bonds and equities. But with so much uncertainty, the prospect of interest rates remaining low at least through this year, a continuing regulatory impetus towards less volatile institutional funds and the ongoing value of holding a balanced portfolio, the transition may be more orderly than the “story” might suggest.
Tom Stevenson is Investment Director at Fidelity.
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