BofA Merrill Lynch head of U.S. equity strategy Savita Subramanian is telling clients to get ready for “the next leg of the Great Rotation” — the seismic shift out of bonds and into equities envisioned by the bank’s analysts.
As this next leg rolls out, Subramanian says fund managers “are likely to stumble upon what may be one of the market’s best-kept secrets.”
“So far the rotation from bonds into equities has primarily been into bond proxies,” she writes in a note. “Given the supply/demand imbalance for yield, we expect equity income inflows to continue. Demographics argue for continued demand, while supply is likely to stay tight as both interest rates and the S&P 500 payout ratio are trending well below average. And equity income remains compelling, with one in five S&P companies offering a dividend yield higher than that of the [10-year U.S. Treasury note].”
As Subramanian points out, 37% of all actively-managed funds that invest in large-cap equities are “equity income funds,” searching for yield. These funds now account for the largest share of the actively-managed large-cap space.
So, what comes next?
Expect continued inflows into taper-proof yield
With stretched valuations and interest rate risk looming for high-yield, ex-growth stocks, the positioning shift we have observed since May is likely to continue as the growing pool of income equity seeks out cheaper, less rate-sensitive stocks that will still meet yield targets. Stocks that offer above-market yields but participate in a cyclical recovery may be most attractive to investors who now have lost money in both bonds and bond-like stocks. These half growth/half yield stocks — which generally offer lower payout ratios and higher cash levels — are better positioned to grow their dividends over time, with strong representation from our O/W sectors of Tech, Energy and Industrials.
The next leg of the Great Rotation: “Quintile 2”
As managers move down the yield spectrum, they are likely to stumble upon what may be one of the market’s best-kept secrets: Quintile 2 by dividend yield of the Russell 1000. These stocks still offer competitive yields, but unlike Quintile 1, enable investors to avoid yield traps and invest in stocks that generally have lower payout ratios, more globally-diversified revenues, less rate sensitivity, and better/more stable growth. Quintile 2 has offered the highest average return and the lowest downside risk over time. Additionally, many of these stocks are household names that even the most gun-shy equity investor may feel comfortable owning.
The table below shows specific stocks that fall into Quintile 2.