Article published in Le Jeudi (Luxembourg) on 8 March 2013 and in Beleggers Belangen (Netherlands) on 8 March 2013.

 

There has been much talk of a “Great Rotation” recently. Strictly speaking, this means a reallocation of portfolios from bonds into equities. In a broader sense, it means a shift into riskier asset classes. Recent statistics on flows show that emerging debt, emerging equities, and, especially, developed equities, are catching on. In the bond world, we have seen a shift from investment grade bonds to high yield corporate bonds and emerging market bonds.

There are several reasons for these phenomena, particularly the renewed interest in equities. The first of these is that investors have been forced to climb the risk ladder since the sharp drop in bond yields in 2012. Another reason is that they have understood that diversification is a must. And diversifying into other asset classes (emerging markets and equities) makes more sense than exclusively chasing higher yields while increasingly sacrificing issuer quality. A third reason may be the renewed confidence in the economic outlook. In many countries, leading indicators are moving up, although forecasters continue to tow a very conservative line. An economic upturn would clearly provide more reassurance on earnings growth. A crucial factor is that equities are cheaper than bonds. This is nothing new, when comparing dividend yields to sovereign debt yields, but in recent months dividend yields have also exceeded yields on investment grade bonds. Dividend yields still come in lower than high yield bonds, but the gap has narrowed. This comparison is skewed in several ways. Firstly, the bond coupon is nominal, while dividends mostly track inflation. Secondly, dividend yields do not reflect retained profits, the reinvestment of which is likely to create value (through higher share prices). For this reason, it is better to compare the earnings yield (i.e., the ratio between earnings and the share price, meaning the reverse of the price/earnings ratio) to bond yields. For US high yield we have statistics that go back 25 years, and for the first time in the history of this index, bond yields are lower than earnings yields.

One clear reason for this is central banks’ policy. Ben Bernanke has hinted that the Fed will stick to its dovish monetary policy; the Bank of England may open the tap wider, and the new governor of the Bank of Japan is preparing to do likewise. The last factor is the correlation between bonds and stocks, which in this phase of the cycle, is negative, i.e., when stocks fall, bond prices rise, and vice versa. This is an argument for a defensive investor to nevertheless diversify into equities. If rising yields bring rising stock prices (as both are pricing in an improvement in the economy) equities are a hedge against the declining bond prices which come with a rise in yields. The US experience has shown that this phenomenon has occurred very often, i.e., cyclical troughs in long-term yields are generally followed by an equity market rally.

It remains to be seen if all investors will join in on the “Great Rotation”. Let’s first point out that, despite the long list of rotation drivers, the rotation itself if not risk-free. Investors should begin by seeing if their investment horizon allows them to take part. The second factor is risk appetite. Here we get into psychology and emotions that very often keep investors from taking risks. The last point is the structure of future liabilities. If I need to generate positive real returns (i.e., after inflation) over time, in order to have enough to retire on, I have no choice but to follow, even if just partially, the rotation into riskier assets, such as equities. The key words here are: diversification and a gradual approach (i.e., spreading out  
entry points over time).

 

William De Vijlder

Chief Investment Officer, Strategy and Partners

BNP Paribas Investment Partners