Great Rotation a myth but stocks still a top pick

February 28, 2013

Feb 28 (Reuters) – Don’t hold your breath waiting for that
Great Rotation out of global bonds and into stocks. Even so, go
into stocks anyway if you are big enough and tough enough to
survive the inevitable volatility.

The idea that investors will soon start to move much of the
cash they’ve plunged into very low-yielding but safe government
bonds into stocks is intuitively appealing. After all rates have
to rise some time and the 30-year-plus bond bull market is
looking long in the tooth. It also makes intuitive sense given
the likelihood of lousy inflation-adjusted returns, even losses,
in bonds.

The only problem is the world is brimming with old people,
rickety banks and foreign central banks, all of whom want and
need safe assets almost without regard to the price.

The upshot: equities will likely outperform bonds over the
medium and long term but returns will be low by historical
standards.

Behind the Great Rotation theory is a fear that when central
banks begin to unload their government bonds, private investors
will bail out, too, driving interest rates up. That will kill
portfolios with heavy bond exposure – and there are a lot of
them.

Don’t bet on it.

“Structural demand for safe havens is likely to remain high
and, when combined with the structural scarcity of such assets,
is likely to keep interest rates on safe assets low,” economist
Michael Gapen wrote in the annual Barclays Equity Gilt Study, a
long-running series on asset markets and returns.

Safe assets are, usually, government debt, which rarely
default and are easily bought and sold even in times of distress
or market dislocation. One of the ironies of the financial
crisis is that even though government debt is objectively more
risky now, demand is higher.

That’s because, in part, if the safest assets are riskier
you need more of them in a mixed portfolio to have the same
absolute level of risk. It’s also because a lot of assets which
were created and bought as “safe” before the crisis – such as
asset-backed securities – proved to be anything but.

By the loose definitions of 2007, safe assets equaled about
35 percent of global GDP in 2007. Take out all the faux-AAA debt
and now that figure is nearer 25 percent, and expected to shrink
in the coming decade. Less supply and more demand equals high
prices.

Figure in that much of the world’s wealth is controlled by
people in or approaching retirement, and you have a recipe for
strong demand for government bonds, even amid a deteriorating
longer-term outlook for government finances. After all, savers
eventually want to eat their assets, and very few have assets
large enough to accept much equity volatility late in life.

As well, new banking regulations being rolled out will force
financial companies to hold many more safe assets, a huge source
of demand. That process has years to run and will help to keep
rates low.

SILVER LINING

Barclays thinks bonds will still do poorly over the next
five years, with safe-haven bonds losing about 2 percent a year
when you take inflation into account. Even though demand will
be strong, economic growth, and some inflation, will eventually
return, eating away at bond values.

Stocks will outperform by 5 to 6 percentage points annually,
but that still only implies a 3 to 4 percent real return.

The gap between stock and bond returns – called the equity
risk premium – is about at the historic average, but absolute
return on equities will be low. Returns on a mixed portfolio
will be even worse, perhaps no more than 1.5 to 2.0 percent
annually.

For opportunistic investors it makes sense to be aware of
the implications of this. I’d be very wary of companies with big
pension fund deficits. Those are only going to get worse. I
would also worry about the effect that this will have, over five
or 10 years, on consumption and savings. There are still good
reasons for savings rate to go structurally higher, and that
means less money flowing around the economy, and, theoretically,
still lower returns on stocks and bonds.

Still, the best advice is to take the best choice in a bad
lot: equities. This is especially true for younger investors,
who may want to consider keeping bond allocations lower than is
usually recommended.

If you are going to lose 2 percent a year on bonds, and
maybe about the same on corporate bonds, the less “safety” you
can afford, the better off you will be.

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