So it might soon be over. The “era of deleveraging” and the outperformance of creditors over debtors might be ending. The celebrity of fixed income, scarce growth and commodities is over. That's the massively bullish call by Bank of America Merrill Lynch (BAML). As 2013 gets under way, asset allocation will shift away from bonds to equities as investors price in growth. Welcome to the era of the “great rotation”, says BAML.
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There are three indicators pointing to the change. Firstly, there have already been obvious changes in positioning, according to BAML:
| “Recent data show the first genuine signs of equity-belief in years. The past 13 days have seen $35 billion come back into equity funds ($19 billion of which is via long-only). And while the industry flow data does not show 'rotation' out of bonds, our private client data does.” |
Secondly, central bank liquidity has been by far the most important driver of asset prices since the financial crisis. But this is changing. The period of excess liquidity is coming to a close. Quantative easing (QE) will become a remnant of the past as an emphasis on other exit strategies slowly start gaining weight, says BAML:
| “The Fed has changed its 'exit strategy', BoE QE has stalled, and the main source of European liquidity injections, the Swiss National Bank, no longer needs to add liquidity via FX reserve accumulation as the Swiss franc begins to depreciate versus the euro. The high liquidity-low growth regime was maximum bullish for bonds. Ultimately, the shift to a lower liquidity-higher growth regime should prove very bullish for stocks.” |
And thirdly, as deflation ends and inflation expectations become anchored within a normal range, risk appetites and interest rates will also normalize, says BAML:
| “Bonds tend to be very negatively impacted by inflation, particularly when it rises above 4%. Meanwhile, in the past 50 years, inflation in the 1-4% range has been the sweet spot for equity returns versus bonds. So long as global inflation remains between 1-4%, investors can look forward to a period of multiple re-rating for equities, provided that EPS grows rather than declines.” |
But this isn’t to say it’s all smooth sailing for equities. Expect some unexpected twists and turns as the transition gains momentum. For BAML, these issues can conveniently be categorized into two separate scenarios. Firstly, there could be a bond crash similar to the tune of 1994:
| “The current level of US jobless claims (335K) is the lowest since Jan 2008, when the unemployment rate was just 5.0%. If the global economy and corporate animal spirits revive sufficiently to cause an upward surprise to US payroll numbers in coming months, say numbers in excess of 300K, then a repeat of the 1994 'bond shock' is likely. “In recent months we’ve drawn a number of comparisons to market returns in 2012 and 1993, the last year banks assumed major global leadership. In 1994 the combination of stronger-than-expected payroll, a tighter Fed, a 200bp back-up in yields led to a big pause in the nascent equity bull market and a savage reversal of fortune in leveraged areas of the fixed income markets. Investors banking on economic recovery should therefore be reducing longs positions in high yield and EM debt." |
A second risk, but less likely according to BAML, is that we could see something similar to the risk shock we saw in 1987:
| “In 1987, rising risk appetites caused equity prices to drag bond yields higher. At the same time, policy tensions over currency valuations between Germany and the US also put upward pressure on bond yields, as well as gold prices. Ultimately the combination of policy risks, rising gold and bond yields helped precipitate the October crash in equity markets. “A repeat of 1987 is a low probability event in 2013. But it is also clear that risk appetite is on the rise, many countries are trying to devalue their way to growth, risking a currency war, and should gold start to respond favourably to this backdrop, we would certainly worry that a major risk correction is imminent.” |
There is a slight anomaly to the whole process. Japan, it seems, is going through a period of reflation. But according to BAML, this is, of course, the “last great reflation”:
| “We remain overweight Japanese equities and would use pullbacks to add to positions. We are always big buyers of 'humiliation' and in the past 12-18 months Japan has sadly racked up the following list of embarrassing landmarks: its third recession in five years, its 11th Minister of Finance in seven years, a violent shift from trade surplus to deficit, government debt topping the one quadrillion yen mark (that’s ¥1,000,000,000,000,000) and the lowest valuation for Japanese bank stocks in over 30 years. “To top it off, the demographics have deteriorated to such an extent that Japan has become the first country where sales of adult diapers now exceed those of baby diapers.” |
A sorry sight indeed. But perhaps not all is lost. Although slightly behind the curve, Japan is also following suit and policymakers are finally taking action. BAML says:
| “The Bank of Japan has adopted a 2% inflation target, will provide an open-ended asset purchase programme, and ¥10.3 trillion of fiscal stimulus. While it will take time for these easing measures to meaningfully stimulate the economy, it’s important to note the impact they have on the medium-term outlook for bonds. “Our Japan bond strategists Shogo Fujita and Shuichi Ohsaki have now revised up their yield outlook beyond the next two years, as they believe the longer-term policy environment is no longer bond market friendly.” |
This month, Ned Davis Research put their weight behind the great comeback of equities. But many would take issue with BAML's projection that central banks are poised to normalize policy rates – as unconventional monetary policy anchors take root, a boost for bonds.