The Great Rotation: A Flight to Equities in 2013
One of the big investment shifts of our day may be at hand — regardless of how global markets actually perform this year.
What's already known as the "The Great Rotation" — a tilting of pension and insurance funds' strategic, long-term asset preference back toward equity from extreme positioning in bonds — has been one of themes of the new year so far.
The gist of the argument is that investor holdings of now expensive, ultra-low yielding government debt — following a virtually unbroken 20-year bull market in bonds — are ripe for rebalancing. The attraction of relative and absolute valuations in equity will coax the outflow to stocks.
It's this juncture that has some of the most persistent global equity bears of the past two decades, such as Societe Generale strategist Albert Edwards, rethinking the big picture.
While there's little thaw evident in his view of an investment "Ice Age" over the next couple of years, Edwards now reckons that over 10 years long-term institutional funds are in danger of missing "the cheapest equity prices in a generation."
From such a committed bear, that's really saying something.
And there are no shortage of shorter-term players hoping to catch the slipstream whenever it comes. Some feel there's no time like the present.
With the whiff of global economic recovery in the air as major central banks floor cash rates, buy bonds and neutralize systemic stability fears, mutual fund and retail investment flows are already on the move in 2013
According to Lipper, net flows to U.S.-based equity funds in the first two weeks of 2013 was, at $11.3 billion, the biggest fortnightly inflow since April 2000 — including exchange-traded funds (ETFs), the number tops $18 billion — well over twice the flow to equivalent bond funds.
What's more, fund-tracker EPFR said some $7 billion of inflows to emerging market equities alone in the first week of the year were the biggest on record and these have outstripped demand for emerging bond funds five weeks running.
But as impressive as these numbers seem, they can still be all-too-easily dismissed as short-term, early-year noise and put in the context of full-year net outflows from equity mutual funds worldwide last year, for example, of some $215 billion — an exit that belied double-digit stock market price gains.
And the new year adrenalin rush can easily dissipate. JPMorgan Asset Management strategist David Shairp, for example, reckons January's buying has become a little indiscriminate, out of sync with a trend toward fewer positive economic data surprises and looking "overdone and in need of pause."
But if you buy the idea of a historic inflection point, then any temporary hiccups just help keep things in perspective.
"Our medium-term conviction in the Great Rotation remains very high," said Bank of America/Merrill Lynch chief strategist Michael Harnett. "But following the sharp rally in risk assets in recent weeks, the jump higher in bullish sentiment, and the still low levels of volatility, we would view a near-term pullback as healthy."
The flow picture that Edwards and others put so much store in is much bigger, stems from the equity exuberance of late 1990s and is rooted in the behavior of slower-moving pension and insurance funds.
It seems incredible by today's standards, but by the early 1990s, British pension funds had almost doubled their allocation to equity over the prior 20 years to a staggering 80 percent of portfolios.
After the solvency shock of two subsequent mega-reversals, a powerful if glacial 20-year reversion to bonds ensued.
So much so that at 43 percent in 2012, U.K. pension funds' holdings of bonds exceeded that of equities for the first time in almost 40 years. The precise numbers may differ, but this broad trend played out similarly across the globe.
European final-salary pension funds surveyed by Mercer last year showed strategic equity allocation among the biggest funds — defined as those in excess of 2.5 billion euros ($3.3 billion) — fell as low as 24 percent from almost 40 percent as recently as 2010.
Of course, never overestimate the speed of change in institutional fund allocations. Regulatory pressures to better match long liabilities, demographic trends and infrequent trustee reviews all sensibly militate against sudden shifts.
But that slow pace of change can also lead to inertia that could keep these funds buying some of the most expensive securities on the planet way past their sell-before date.
If market ebbs and flows or shifting economic winds are unlikely to alter the behavior of those who manage defined-benefit pension schemes any time soon, what will?
A mega shock to bonds may hurry some decision makers, but that's hard to see as long as central banks effectively underwrite these markets via quantitative easing.
Maybe a convincing 10-year horizon would focus minds.
British asset manager Standard Life Investments conducted that exercise this week, using its own assumptions on average inflation, dividend and rental growth and bond yields over the coming decade.
For one, the potential downside to 10-year inflation-adjusted returns on government bonds in the U.S., Europe, and Britain was seen as greater than best-guess gains.
SLI's conclusion was that longer-term investors should now shift to the riskier end of the spectrum in equity and real estate with good starting yields — seeking what strategist Andrew Milligan called "a sweet spot of investment returns over the coming decade."