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December 28, 2012 5:31 pm
Farmers rotate crops to maximise harvests from their fields. As 2012 ends, the same principle could apply to financial markets.
Strategists wonder whether the next year will be the time of a “Great Rotation”, a significant acceleration in flows out of safe, recession-proof assets such as government bonds and into equities.
Investors have seen central banks sowing the seeds of an economic pick-up and stabilising the eurozone debt crisis. And despite this week’s market gyrations with every twist of the political drama in the US, investors have broadly kept their faith that a deal of some kind will avert the worst of the automatic tax rises and spending cuts known as the fiscal cliff.
Expectations of a better global outlook have risen, while returns on bond markets look increasingly hard to sustain, since interest rates have set still more historic lows in 2012.
Jay Mueller, portfolio manager at Wells Capital Management, says: “Everyone is shaking the bushes pretty hard to find yield, but there’s not much left.”
Little wonder there has been an increasingly frantic “hunt for yield”, with normally conservative investors searching for riskier, better performing assets, such as corporate debt or in emerging market economies.
In 2012, it was successive rounds of quantitative easing by the US Federal Reserve, plus European Central Bank pledges to backstop eurozone debt markets, that helped drive interest rates to historic lows at the same time as removing “tail risks” – catastrophic events that could have plunged the world into economic depression.
“Asset prices have been artificially inflated by central banks,” says Andrew Balls, head of European portfolio management at Pimco. “The big question is how far can this game continue? Are there risks in terms of policy effectiveness? Will central banks have to do more to maintain the status quo?”
European equities rallied strongly from late July, when Mario Draghi, European Central Bank president, promised to do “whatever it takes” to preserve the eurozone’s integrity. Even after an end of year dip on US fiscal cliff worries, the FTSE Eurofirst 300 index ends the year almost 14 per cent higher than at its start. US equities have rallied since the presidential election in November, with the S&P 500 up only a percentage point behind European equities.
Everyone is shaking the bushes pretty hard to find yield, but there’s not much left
- Jay Mueller, Wells Capital Management
“Rotation by stealth” is under way already, says John Bilton, European investment strategist at BofA Merrill Lynch, who points to investors returning to previously unloved assets such as eurozone bank stocks. The “great rotation” will be a “major theme” in 2013, he says. “Equities will become more attractive because they are geared to growth and offer returns that investors simply cannot get from their bond portfolios.”
The snag with “great rotation” forecasts, however, is that evidence of large-scale conviction, investing in equities is not overwhelming. Despite bullish expectations about economic growth, investors have this month held equity allocations at November’s levels, according to a survey of almost 200 global fund managers by BofA Merrill Lynch. “Although they are becoming more positive about the world, they have not yet put their money to work,” admits Mr Bilton. The exceptions were hedge funds, which increased their net exposure to equities to the highest level since August 2006.
Some warn that optimism is getting out of hand. “US equity markets are priced on unreasonable expectations about profit margins,” says Paul Marson, chief investment officer at Lombard Odier. In Europe, he remains sceptical about progress towards putting on a sustainable footing the public finances of crisis-hit eurozone countries such as Spain. But he still spots opportunities. “If you buy an equity you get a claim against a company not a government. Would you want to own a good quality corporation in Europe or even Japan at what are considered modest valuations? I absolutely would.”
If confidence in the global economic recovery does build, the shifts in investment portfolios should gain momentum. The danger then would be of a “great rotation” turning into a rout in government bonds and over-bought parts of the corporate debt market.
Few investors expect the Federal Reserve, ECB or Bank of England to begin withdrawing support for economies any time soon, and central bankers will try to control the process. But the risk is of a repeat of the turmoil seen in 1994, when the Fed surprised markets with aggressive interest rate rises, causing big losses for investors.
Would you want to own a good quality corporation in Europe or even Japan at what are considered modest valuations? I absolutely would
- Paul Marson, Lombard Odier
“If economic growth gains traction anywhere then, in their inimitable way, markets could call time [on ultra-loose monetary policies] a long time before exit strategies are in place,” warns George Magnus, economic adviser to UBS.
The chances of choppy conditions are higher because, as a result of regulatory reforms, banks have reduced their holdings, or inventories, of corporate bonds. Ensuring a smooth sell-off could therefore be harder.
Some are already sounding the alarm. Investing in “safety” in fixed income assets could become the “new tail risk”, warns BlackRock in its 2013 investment outlook. Like farmers, investors need to know which way the wind is blowing.
Additional reporting by Michael MacKenzie
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