Great Rotation hovers on the horizon (Hasenstab + Arnott)

When will there be a change in the wind? For four years it has blown investors in one direction: out of stocks and into the relative safety of bond funds.
But while there are plenty of warnings that bondholders face losses from rising interest rates, rallying stock markets have yet to be propelled by a real gust of enthusiasm.

Flurries of interest in the new year, though, have brought rising interest in the idea of a ‘Great Rotation’: the idea that money will flow out of bonds and back into stocks.
US stock funds attracted $21bn in the first four weeks of the year, according to Lipper, the largest inflow for any four-week period since the peak of the dot-com boom in April 2000.
Meanwhile equity funds globally took in assets at three times the pace of bond funds, according to EPFR. The research group also found that equity flows from retail investors, who tend to be slow to react to turning points in markets, are on track for the strongest start to the year since 2006.
The inflows come as some influential bond investors have already positioned themselves to avoid interest rate risk.
“There’s probably a growing understanding that interest rates have to go higher at some point,” says Michael Hasenstab, who oversees $175bn in fixed income for Franklin Templeton. “We’ve actually taken that conviction and put it in place.”
At the same time there are signs of investor optimism. UBS says its long-only and hedge fund clients were net buyers of equities in crisis-hit eurozone “periphery” countries in eight of the last 11 weeks, with average flows at the highest level in more than two years. Unloved Spanish equities have seen buying for four weeks in a row.
But Nick Nelson, UBS global equity strategist, argues for context. “It is not a rotation, it is a mini-rotation. It doesn’t look to us that it’s euphoria or super extended,” he says.
And Romain Boscher, head of equities at Amundi, says that in Europe it is not as simple as money flowing from fixed income straight to equities. “This is not new money moving in favour of equities. We’re just seeing money that left Europe coming back again.”
Indeed, the term is in one sense a misnomer. “Every stock certificate and bond certificate must be owned by someone at every point in time,” says John Hussman of Hussman Funds.
Rather it reflects the sentiment at the margin, where new savings are directed, and increased demand for stocks is still tentative and cautious.
“We’re still in a world where if there’s a shock to equities, bonds will do well. So bonds still play an important role as a diversifier. In five years’ time, who knows, but stocks and bonds stapled together are a very interesting investment in the near term,” says André Perold, chief investment officer for HighVista Strategies, an investment firm for endowments.
Patrik Schowitz, global strategist for JPMorgan Asset Management, says he is overweighting stocks relative to bonds, but largely because the latter are so expensive.
“It would certainly help if we had a rip-roaring economic environment,” he says.
Robert Arnott, who runs two asset allocation funds for Pimco, sees recent moves in the stock and bond markets as opportunities to be tactical, selling what has rallied and buying what has fallen.
He also says the source of January inflows may simply be the flurry of bonuses and special dividends paid out in the US ahead of this year’s tax rises. He describes this as “a flood of demand from income that would have normally occurred in January, February and March that needs a home”.
Even were there a greater sense of optimism though, there is much built-in inertia at big investors such as pension funds and insurers.
Solvency regulations in Europe encourage insurers to hold bonds, while accounting rules have pushed US pension funds in the same direction.
“A good two-thirds of corporate pensions have put derisking plans in place,” says senior Mercer consultant Richard McEvoy.
That will continue a trend which the consultancy calculates has caused pension funds of S&P 1500 companies to cut equities from 65 per cent of assets to 50 per cent over the past decade, while bond allocations have risen 10 percentage points to 39 per cent.
So the investment weather remains mixed. Looking back over his 44-year investment career, Charles Brandes, chairman of Brandes Investment Partners, says the current period most reminds him of 1980.
In 1974 the US market dropped 47 per cent. It rallied in the following two years, but by 1980 interest rates were rising to combat inflation and the economic outlook remained uncertain. “It wasn’t until 1982 that we saw the start of the big bull market, and maybe we are two or three years away from that,” says Mr Brandes.