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While financial analysts have long predicted investors would switch out of low-yielding bonds into equities, to date there has been very little evidence of it happening. That could finally be set to change, argue James McAlevey* and Marc Semaan*.
Ever since Bank of America Merrill Lynch’s chief investment strategist, Michael Hartnett, coined the term the “Great Rotation” in 2012, there has been no shortage of financial analysts predicting that investors are about to switch out of low-yielding bonds into equity shares. After all, one of the main goals of central banks in purchasing government debt and pushing down interest rates has been to encourage investors to take more risk. However, to date there has been precious little evidence of it actually happening. Investment flows have remained overwhelmingly in favor of bonds.
It is true equities have risen sharply over the past eight years. But that has had less to do with global investors rebalancing their portfolios towards companies’ shares and more to do with the financing practices employed by the companies themselves. The decline in interest rates resulted in one of the largest financial engineering exercises in history, as companies looked to boost shareholder returns – and their own share prices – by issuing a significant amount of debt and using the proceeds to buy back their own equity or return cash to shareholders in other ways.
Investors’ reluctance to switch into equities is clearly illustrated by examining global investment flows into equity mutual funds. As can be seen from chart 1 below, they have been comparatively weak ever since the financial crisis. Meanwhile, flows into bond mutual funds have risen sharply.
Chart 1 – Global investors still favoring bonds over equities
Source: Deutsche Bank, based on calculations of all equity and bond ETFs in the EPFR Global database, as of 5/31/2017. Past performance is no guarantee of future results.
Have investors stopped chasing returns?
There is evidence to suggest that where retail investors choose to put their money is primarily determined by how individual assets have performed in the recent past. In other words, investors tend to “chase” returns.
Taking the US as an example, as chart 2 demonstrates, in the 25 years that preceded the financial crisis there was a clear relationship between the relative performance of US equity and bond markets over the preceding nine months and relative flows into these two asset classes.
For most of the 1990s, equities consistently outperformed bonds, leading in turn to more money flowing into equities than bonds throughout the period. Likewise, between 2000 and 2002, and 2007 and 2009, steady outperformance by bond markets meant fixed-income investments secured the lion’s share of new investment flows.
Chart 2 – Investment flows linked to past performance
Source: Deutsche Bank, Thomson Reuters DataStream, based on equity and bond fund flow data from ICI, as of 5/31/2017. Past performance is no guarantee of future results.
However, as chart 2 also shows, for much of the period since the financial crisis erupted, this relationship has been far weaker. Although equities have comfortably outperformed bonds for most of this period, investors have continued to favor bonds to a far greater extent than would have been expected on the basis of the historical relationship.
There has been no lack of a carrot enticing global investors into rebalancing their portfolios in favor of stocks. However, at least in the case of US retail investors, that has been insufficient to revive their appetite.
Why have investors favored bonds?
We believe there are three possible explanations as to why investors in the US, and elsewhere in developed markets for that matter, have refrained from buying equities as heavily as might have been anticipated.
The first possible explanation is that, no doubt mindful of having suffered two major drawdowns over the previous decade, US investors have understandably been reticent to invest in shares for fear of being burned a third time. After all, it took almost seven years for the S&P 500 to regain lost ground after the dot-com bubble burst in 2000; almost as soon as it had, the financial crisis started to take hold in late 2007, leading to another crash in the index that took another five and a half years to recover from.
By contrast, they have been comfortable investing in fixed income: firstly because yields couldn’t really move much because of all the central bank buying; and secondly because of the comparatively attractive levels of income on offer.
The second potential reason why investors have favored bonds is that demographic factors in the West have caused structural shifts in the investment marketplace, which have worked to counteract the impact of outperforming equity markets. Older investors, who are typically more cautious and therefore favor owning bonds over equities, have been growing in number faster than younger ones who tend to favor equities.
The third explanation is that although the level of returns delivered by bonds may have been inferior to those generated by equities in recent years, they have still been positive. Given the first two factors, it could be that investors have concluded that so long as bonds have been performing satisfactorily, there has been little need to switch into equities regardless of how strongly they have performed. For many, it seems the furthest out along the risk spectrum they were prepared to venture was into high-yield bonds.
Besides, while bonds may have provided inferior returns to equities across the bond market as a whole, high-yield bonds have actually served up similar returns to equities since the financial crisis with significantly less volatility.1 In one sense, investors would have been right to ask themselves: why take the extra risk of owning equities?
Contending with a stick
However, the situation could be set to change since it looks as if investors, in addition to a carrot, may soon have a stick to contend with. That is because while bonds may not be about to fall off the edge of a precipice, the US Federal Reserve (Fed) is now firmly in rate-hiking mode. All of a sudden there is a more immediate prospect that the era of unprecedented monetary policy easing is drawing to a close across the West. As a result, bonds may struggle to generate positive returns for much longer.
Faced with the prospect of earning negative returns on bonds, investors will likely have limited appetite to continue accumulating the asset class. As can be seen in chart 3, money has tended to flow out of bond funds during periods of rising interest rates.
The one exception was the period between 2004 and 2007. However, this was unusual in that it was a time when foreign central banks were aggressively building up their reserves and Japanese investors were looking to secure the higher yields available in the US market.
Chart 3 – Rising yields tend to trigger bond outflows
Source: Deutsche Bank, ICI, as of 5/31/2017. Past performance is no guarantee of future results.
No secular stagnation
For some commentators, particularly advocates of the “secular stagnation” theory, the absence of a strong cyclical upswing nearly eight years on from the end of the last US recession is evidence that the extraordinary monetary policy measures of the past nine years have failed. Furthermore, they argue that with the world economy still relatively fragile and debt-to-GDP ratios so high, it would be unwise in the extreme to reverse monetary easing at anything more than a glacial pace.
The boom in non-financial corporate bond issuance is a primary reason the Fed and other central banks will be unable to tighten policy materially further, according to these commentators. They take the view this level of debt will be unsustainable at higher rates of interest. In such circumstances, the Great Rotation will continue to prove elusive.
However, there are flaws in this line of reasoning. For a start, much of this corporate debt has been issued with long maturities so will not need to be refinanced for a long time. Secondly, to the extent it has been used to buy back stock, companies can simply reverse this process without incurring a loss and potentially even book a significant profit.
Furthermore, in light of the recent strengthening of global economic activity, we are increasingly confident the world will be able to cope with the gradual withdrawal of monetary support, at least in the initial phase of the process. After all, the measures taken in recent years seem to have had many unintended consequences that have limited their impact and in some instances been wholly counterproductive. As such, the removal of this monetary support, far from stifling the recovery, may actually be beneficial should some of these adverse effects begin to reverse.
If the latter stages of monetary easing have indeed been counterproductive, tighter policy may actually underpin the recovery and reinforce the first genuine economic upswing since the financial crisis. If further support were needed in the event the recovery stalled as policy was tightened, a more sensible course would be to attempt to stimulate activity via fiscal policy instead.
All of this is not to deny legitimate concerns about the potential impact of tighter monetary policy further ahead. Governments’ ability to borrow will be more constrained, especially since funding costs look set to rise. And tighter policy will eventually hinder consumption if rates begin to rise sharply. But for the next three years or so, so long as central banks do no more than remove some of the excesses that have built up in recent years, we see no reason why economic growth cannot continue to accelerate as all the unintended consequences begin to unwind.
Investing is about to get more difficult
We believe investing is about to get a lot more challenging as the global monetary experiment of the last decade unwinds. Whereas in recent years it has been sufficient to focus on liquidity and technical factors, going forward it seems fundamentals will reassert themselves.
The “risk-on, risk-off” approach that was dominant in the highly correlated world of recent years is unlikely to prove profitable as the correlation between and within asset classes breaks down.
Nevertheless, there should still be plenty of profitable opportunities for those investors able to do their homework, correctly assess fundamental factors and not merely rely on the actions of central banks to float all boats simultaneously.
While the majority of central banks – at least initially – will wish to remove monetary stimulus in a gradual fashion, it seems certain bonds will struggle in the coming years. However, equities could do much better than many expect as they should begin to appear relatively attractive to investors.
Even though history suggests equities tend to suffer once interest rates rise above 4%, rates are currently so low that tighter monetary policy appears to present little threat. For the time being at least, the likely improvement in economic fundamentals should outweigh the impact of higher interest rates and leads us to expect a growing number of investors will begin favoring equities over bonds.
We do not necessarily expect a mass exodus from bonds, although that could happen if bond yields rise materially. But as savings continue to accumulate, we believe fresh investment inflows are increasingly likely to favor equities.
To date those rotations that have taken place since the financial crisis have been within asset classes. For example, we have seen funds flowing out of more highly-rated segments of fixed-income markets in favor of riskier areas such as high yield, as evidenced by the collapse in yield spreads. Similarly, within equity markets there is clear evidence that record-low interest rates have encouraged investors to favor income-generating stocks over those with growth potential.
However, with the Fed now firmly embarked on monetary tightening, at least in the United States, the necessary conditions for the Great Rotation to finally get underway – with investors switching not just within but across asset classes – look finally to be in place.
1 Since July 2007 the Barclays global high yield total return index has delivered an annualized return of 9.0% with average annual volatility of 8.5%. By contrast, the S&P 500 index has delivered an annualized return of 8.7% with average annual volatility of 14.2%: source, Bloomberg.
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