Michael Wilson believes in Santa Claus, the tooth fairy and his lucky pixie clover leaf. But the Great Rotation? No way:
There are some things in life that just seem so obvious that you hardly stop to question them at all. It gets cold in winter and warm in summer. Except when it doesn’t, of course. Your gas bills never come down, even when the gas price does. And your car insurance keeps getting more expensive even though we have fewer crashes and fewer car thefts these days.
But if the big buzz concept of the last 12 months has been hoping to slip under our collective radar as a matter of simple, obvious logic, it’s got a few more hurdles still to conquer. The so-called ‘Great Rotation’ – the tempting idea that softening bond yields are driving a surge into equities – is proving a lot more elusive than its proponents might have suggested.
The idea of a Great Rotation was first put about, just over a year ago, by Bank of America Merrill Lynch analysts, in a report entitled “The Bond Era Ends”. And for a while it seemed to be all the rage. But IFA Magazine’s 2013 series of seminars has given us an excellent opportunity to talk to our adviser readers and our fund manager speakers about what think is going on. And the fund managers are telling us a clear story. Retail investors in the UK aren’t dumping their fixed interest in any great numbers, they say, and institutions are only just starting to reconsider their allocations.
The Case In Favour
Is that correct? We’ll be looking at some conflicting figures shortly. But let’s not beat about the bush. On a simplistic level, some of the fundamentals for a Great Rotation do seem to be in place. Bonds have spent most of the last thirty years in a bull phase, with yields on premium benchmarks dropping to 2% and often well below that. Before 2007, that was simply a case of fixed interest moving in line with equity returns and rising p/e ratios; after mid-2008, however, it was clear that a perceived weakness in equities was driving anxious investors into the arms of the only true safety net they could find.
The position was later compounded by the euro zone’s banking crises, and by the Greek budget disasters, which drove southern European bond investors into British and German bonds instead. The result was that gilt yields were driven all the way down to 1.5%, and that German bonds actually went negative for a while, so great was the demand. Okay, these were peculiar results, caused by one-off events, but we couldn’t really paint a proper picture of the situation without mentioning them. As China also ran into trouble, we had a whole series of special reasons why this very real situation should have been happening.
Whichever way you look at it, bond funds made up only 23% of sales of long-term funds in the US, during 2007. But by 2012 that figure was up to a massive 40%. And in first-half 2013 it was still 39%, but dropping away at some speed. You see what we mean about slowly the institutions are moving?
So is all that investor interest moving into equities, as the bulls suppose? It isn’t clear. You could hardly say that the global equity scene has exploded with optimism since the US Congress voted to kick the can down the….. er, no, sorry about that, to agree on a short-term extension of the deficit limit that will see America through until January, when the whole shouting match on Capitol Hill will start all over again.
The unhappy truth is that a short boost of stock market confidence in the days after the October settlement had given way to a distinctly flat mood by the last week of the month. And that this same lack of confidence was also apparent in Europe, in the UK and in Japan – all of which looked as though they were whistling quietly in the wind. With p/e ratios stalling, and with cyclically-adjusted Shiller ratios already fairly close to their long-term averages, there didn’t seem much room for irrational exuberance. So it was rather odd that this infectious substance still seems to be around.
Do The Maths
How can we explain all this? Let’s start by looking at what’s happened to bond yields in the last 16 months. Between January and September 2013 the benchmark ten year treasury yield rose from 1.61% to 2.92%, before dropping back to 2.52% by the end of October. Now that’s a 93 point rise if you look at it one way – and a 56% dilution if you view it through the other end of the microscope. Indeed, if your starting point had been as far back as the low point of 1.43% in July 2012, you’d have been looking at a 57% dilution.
So are we really saying that the value of those bonds has shrunk by half in the last 16 months? Yes, actually we are, although some reversion to the coupon price should also be taken into account.
So, by that logic, the expectation would have been that the equity markets should have received an equal kind of uplift, right? I mean, if investors aren’t keen on cash at minimal rates of interest then they’re going to be drawn toward the old counterbalance, shares. Yet the S&P 500 has risen by ‘only’ 29% since the July 2012 peak, while the Footsie has gained 18%.
Wrong, wrong, wrong. As Stephen Spurdon’s article on investor logic (Page 44) explains, the human brain is raddled with thinking bugs, and this is one of them. If we suppose that a million people losing money on the bonds end of the seesaw is going to mean a million people jumping off and walking over to the equities end, then we’re dangerously mistaken.
• Firstly, because it’s a fallacy to suppose that everybody is free to make the choice between bonds and equities. The biggest bond players are the pension funds who – you’ve guessed it – rather like having their money in the copper-bottomed bonds market, for the simple reason that their account holders can’t always afford the short-term risk of the equities markets.
• Secondly, because the demographic impetus is still in favour of reducing risk. There are maybe 200 million baby boomers born between 1946 and 1964 who’ll be looking toward retirement in the next decade – that’s including 75 million in the US and 100 million in the EU, by the way – and even a more attractive risk environment won’t bring all that many of them back into the embrace of the equity markets.
• Thirdly, because a lot of bond investors will really be quite happy with a bounce in bond market yields. Here in Britain, annuity rates have risen by about 7% since the start of this year, which has been a blessing for any pensioner who might have been holding off on his annuity conversion. The driver here, of course, is that UK annuity levels are effectively set by the gilt yield, which has been rising quite nicely.
Morgan Stanley has been one of the latest to query the logic of those who expect a major transfer of funds toward equities. Some 60% of its $89 trillion of global assets under management are being held by institutional investors, it says, and any reallocation by these bodies will be equity neutral, “at best”, it says. (“Great Rotation? Probably Not”, from www.morganstanley.com/views/perspectives/index.html)
“Defined Benefit Pension schemes are likely to reduce equity allocations, as they de-risk to better match assets and liabilities, and Solvency II regulations for Insurers will confine re-risking to non-equity assets…..We think aging demographics and lower risk appetite will focus investor demand on regular income, capital preservation and lower volatility of returns, limiting the strength of any rotation into core equities,” the report concludes.
What actually seems to be happening is that consumers who sell out of bond funds are stashing their cash into deposits. Cash? At these interest rates? You’d better believe it. The quantity of cash on the stock market sidelines these days is staggering. And sobering, if only for what it tells us about investor expectations.
The End Of Innocence?
But it’s the fourth factor that really makes me wonder about the logical processes of those who expect quantitative easing and the taper to push the move into equities. And, as you might expect, a lot of the feelgood stuff is coming from the fact that the Federal Reserve is looking like it might finally come good on its pledge to reduce the volume of quantitative easing from its current $85 billion a month.
Okay, the Fed flirted with the idea of the taper back in September, but the bond markets instantly went so hyper that chairman Ben Bernanke very sensibly backtracked on his plans to start winding down the pressure. But, two months on, it does seem likely that he, or more probably his successor Janet Yellen, will turn the end of QE into a gradual reality.
If this happens, the only possible inference is that Treasury bond yields will soon start to rise. And the theory is that, as soon as bond holders start to fear that the prices of their investments might plummet, we’re going to experience a sell-off that can only benefit equities?
Well, I have to admit that when you put it like that it does sound kind of logical. But when you look at it properly, the assumption that what’s bad for bond prices in 2014 is likely to be good for equities is absolutely crazy.
Why? Because it ignores two central facts:
• One, the end of tapering is going to push up the cost of borrowing and take all the shine off the recent improvements in US profits growth.
• Two, it’ll make it more expensive for the US Treasury to roll forward its massive budgetary overdraft, which is in the process of being extended as we speak.
Oh, for sure, the inevitable rise in interest rates won’t hurt the Treasury on the existing bonds – a coupon is a coupon, after all. But when the next round of bond auctions starts, post-tapering, we’re likely to see some much higher rates kicking in. How can that not turn into higher taxes or fewer services?
And maybe we should also consider the hideous size and scale of the QE experiment. It’s hard to think of a single occasion in post-war history when the US body corporate has received such a massive dose of stimulant directly into its veins. And we’re in completely untested territory when we try to estimate how the after-effects will pan out. That, and the effect that the Tea Partiers have pretty well wrecked America’s confidence in its congressmen, must mean that there will be no return to ‘normality’ any time soon.
In the meantime, here’s a final thought. According to JP Morgan’s figures, global retail demand for bonds in the first eight months of 2013 was $700 billion lower than in the same period of 2012 – and if you include commercial banks, the shortfall looks closer to $1.6 trillion. In fact, just about the only thing that’s correcting the balance is that central banks bought $900 billion worth of bonds as part of their quantitative easing strategies. The inference here is that the actual swing away is a ‘mere’ $700 billion.
Which would be great, if only it weren’t for the fact that governments everywhere except Japan seem set on chopping back on QE. Anybody got an answer to that worry?