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Equity bulls believe that this may be the beginning of a significant asset allocation shift towards equities and away from bonds. As this rotation gathers speed, it may drive equity prices upwards. Most investors concede that sovereign bonds have no valuation support, are over-owned and are a hiding place. This has led to the belief that, as risk appetite builds, investors should be more willing to move money into equities. The whole credit complex, anchored as it is to spreads over a minuscule and manipulated sovereign bond yield, seems ripe for investors to take profits.
Emerging market bulls have understandably latched on to this rotation thesis. Any revival of risk appetite and move into equities should be very supportive for emerging market flows and equity valuations. As money moves back into equities, the bulls feel emerging market stocks should get a disproportionate share. This thesis has been borne out in the last few weeks.
Though intuitively appealing, especially given how well the fixed-income asset class has done over the last decade, does this rotation thesis have analytical backing? Yes, everyone knows bonds are over-owned; but can this rotation from bonds into equities really drive equity’s absolute performance?
This idea of a large rotation from bonds into equities as being a driver of equity performance intuitively assumes that there must have been a large move in the other direction towards bonds over the last decade, something that will now be corrected. While data do show that there has been a large inflow into debt products over the last few years, this money has come from cash and money market products, rather than from equities (sourced through Morgan Stanley research; all data relate to the US). Given the onset of financial repression, and the inability to get any yield at the short end of the curve, investors have reduced their holdings of money market products and moved into bond funds and income products to capture whatever yields they can. While equity mutual funds have seen significant redemptions of almost $450 billion since 2008, these outflows have been matched by similar inflows into equity exchange-traded fund (ETF) products. There seems to have been a shift in how investors access equity markets – from actively managed funds into ETFs – rather than a wholesale rejection of the equity asset class, as some may believe. People seem to have voted with their feet against active management, rather than spurning equities as an asset class.
This shift towards ETFs is a longer-term trend, one seen globally, and is driven by the fact that the majority of actively managed funds underperform their benchmark. There is also a realisation that in a low-return world, the difference between a cost of nine basis points (the cost ratio of a US equity tracker) and the typical 100 basis points-plus that you pay an active manager cannot be justified.
Thus, if we have not really seen a very active asset allocation shift away from equities, does this rotation trade idea have any legs?
There is also a strong perception that large institutional investors, such as pension funds, have skewed their asset allocation away from equities over the last few years. There has been much comment that many pension plans are at decade-low levels of equity exposure. However, data provided by Morgan Stanley seem to contradict this widely held view. In a recent note, it pointed out that when you consolidate pension fund holdings of mutual funds for all US pension assets, equity allocations are actually above the long-term average, at just over 50 per cent. There is not that much room for this percentage to go higher. Pension plans are unlikely to move to an allocation over 60 per cent (the peak seen in the Morgan Stanley data) in the current environment.
In addition, the folks at Morgan Stanley point out that their internal team that tracks pensions, endowments, and foundations and their flows, actually believes that in the next rebalancing cycle these institutions will sell equities and buy bonds. This is based on the current positioning and the recent outperformance of equities versus bonds. Their data do not indicate any large pent-up demand for equities.
The other problem with the rotation argument is that, in aggregate, even if you believe that money will move from bonds to equities, someone has to buy the bonds you are selling. There has to be someone on the other side of the trade who will sell you his or her equity and get cash — and someone has to buy your bonds. It is not possible, in aggregate, for the markets to rotate out of a fixed stock of these assets; someone will have to continue holding these assets at all points of time. Given the huge deficits being run by governments globally and the lack of de-leveraging when public and private debt are both considered, the issuance of debt is not declining, nor is the total stock of debt. With no reduction in the stock of debt, no capital will be released on a system-wide basis to move into equities. The existing outstanding quantity of stocks and bonds is held by someone currently; a rotation may cause the identity of the holders to switch, but it does not change the fact that the entire quantity will still be owned by these market participants.
Also, though it is important to track fund flows – and they do matter for short-term performance – valuations, earnings growth, global economic conditions and corporate confidence are more important in determining long-term performance when it comes to equities. The flow-of-money arguments serve better as short-term trading signals.
Equity markets have begun 2013 in fine fettle. Investors have begun to regain confidence, and some of the tail risk issues seem to be on the back burner. Even if equities do well this year, it won’t be driven by the concept of rotation from bonds into equities. If equities do well, it will be because we will have made progress on the task of working through the aftermath of any great financial crisis.
The writer is fund manager and CEO of Amansa Capital
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
