Some See ‘Great Rotation’ Beginning

Anticipated move out of bonds into stocks may now have started.

Reviewed by: Dhara Ranasinghe and Vikram Subhedar
Edited by: Dhara Ranasinghe and Vikram Subhedar

(Reuters) – After a number of false starts since the term was first coined five years ago, the idea of a “great rotation” out of bonds into stocks is again gaining traction.

Almost $2 trillion has been wiped off the value of global bonds since Donald Trump was elected as the next U.S. president on Nov. 8, sparking a reassessment of growth and inflation views. In contrast, U.S. stocks have hit record highs.

According to Bank of America Merrill Lynch, the week to Nov. 16 saw the biggest equity inflows in two years, at $28 billion, and the biggest bond outflows in 3 1/2 years, at $18 billion—the widest weekly disparity between stock and bond flows ever.

Whether this marks the start of a “great rotation,” a phrase first used by Bank of America in 2011, remains to be seen, but there are two reasons why this time it could be the real thing.

Why This Could Be Real Thing

For starters, say analysts, a tighter U.S. jobs market and signs of stronger economic growth suggest inflation risks are rising.

Second, for the first time since the financial crisis, there is a shift toward fiscal expansion—highlighted by the economic policies favored by Trump and by Britain's budget statement this week that unveiled a $29 billion fund for infrastructure projects.

That change implies higher borrowing by governments and another source of inflationary pressures that support a view that an era of ultra-low-yielding bonds may be in the past.

The only caveat is that this notion of investors shifting their hundreds of billions invested in bonds into stocks as a three-decade bond bull run comes to an end, propelling equity markets higher, has had several false starts before.

What’s Different This Time

"I've been asked this question many times before—about whether we're seeing a great rotation," said Luca Paolini, Pictet Asset Management's chief strategist. "We now see some significant inflation risks that were nonexistent before. This is what's different."

In Germany, signs of a pickup in inflation pushed yields sharply higher from record lows between late April and June last year—only to fall back as data suggested the region continued to battle with deflationary pressures.

U.S. 10-year bond yields rose more than 100 basis points during the so-called taper tantrum of 2013 as investors positioned for a scaling back of U.S. monetary stimulus. They subsequently fell back too, hitting record lows earlier this year, helped by a perception that any Federal Reserve monetary tightening would be gradual to support growth.

A Fed rate hike next month, widely expected, would mark the first increase in a year.


Turning Point

But as inflation expectations are overhauled, so are perceptions about the rate outlook—money markets are starting to price in one or more Federal Reserve rate hikes next year, a sea change from before the election, when they priced in a less than 50% chance of a 2017 Fed hike.

It's against this backdrop that early indicators of a rotation can be seen.

J.P. Morgan also noted that, over the past week, a record inflow into U.S. equity exchange-traded funds was accompanied by a record outflow from bond ETFs.

Within equity markets, a sharp rotation out of so-called bond proxiesdividend-paying sectors such as utilities, telecoms and health care, which are favored by investors for their yieldand into more cyclical sectors such as banks, industrials and commodities-related sectors, is already underway.

Dividend Fade May Be Precursor

The fading allure of dividends could be a precursor to a broader asset-class switch out of bonds and into stocks, which are more geared to economic growth and an inflation pickup.

This trend has taken hold across global equity markets. Basic resources and energy are now the best-performing equity sectors within the MSCI all-country World indexes, both up about a fifth this year. Health care, utilities, and food and beverage stocks are the biggest laggards, and the only three in the red for 2016.

"It's too early to tell, but this is the best chance I've seen in a long time," said Michael Antonelli, an institutional sales trader at R. W. Baird & Co., referring to a great rotation.

"Money chases performance, and it is thus and ever shall be, so we need equity funds to start knocking the cover off the ball," he added, alluding to an opportunity for equity funds to make strong gains.

What To Look For Ahead

One sign that a great rotation is taking hold is if investors continue to offload bonds on a large scale.

"We know in general that a lot of capital has gone into fixed income, so how investors react to this sell-off is really important," said Michael Metcalfe, head of macro strategy at State Street Global Markets. "If they capitulate, they will drive the next leg of it clearly."

Any rotation is likely to be driven by the United States, where bonds have seen some of the steepest selling in years. In Europe and Japan, still-subdued inflation and ultra-loose monetary policy are expected to provide some support to bonds.

Rising political risks in the euro area such as in Italy also suggest demand for safe-haven German bonds remains firm, with two-year yields hitting record lows on Friday at minus 0.75%.

Long-term investors such as pension funds, hurt by an era of negative bond yields, are also likely to welcome any sell-off to lock in yields at higher levels.

"Against that, you could have someone like a retail investor not wanting to own fixed income. So really the idea of a great rotation will depend on who that marginal buyer or seller of fixed income is," said Nick Gartside, chief investment officer for fixed income at J.P. Morgan Asset Management.