The Great Lie Of The Great Rotation
Both the recent increase in interest rates and renewed questions about the duration of QE3, sparked by the release of the December FOMC minutes, have raised concerns about a 'Great Rotation' out of credit and into stocks. Barclays notes that the story goes something like this: negative total returns in fixed income and increasing equity prices will drive investors to sell the fixed income assets they have accumulated over the past several years and buy stocks. This “Great Rotation” will force investment grade corporate spreads wider. However, in nearly 100 years of data, Barclays finds no evidence of a period when rates rose, spreads widened, and equity returns were positive.
Risky assets are generally correlated, and when interest rates increase, this is usually because of an improving fundamental backdrop that drives risky asset prices higher. Sharp increases in interest rates have happened many times, including several instances post-crisis. In almost all of these periods, credit spreads tightened, as the moves were driven by improving macroeconomic fundamentals.
The few times that higher rates were accompanied by wider spreads happened in the 1970s and early 1980s, when inflation was accelerating. In each of these periods, equity prices fell sharply. As we have been warning, credit spread deterioration has tended to front-run equity weakness (with some false positives) but never with the divergence remaining consistent as a 'rotation' would suggest.
The only outflows associated with higher rates have been small, short-lived, and offset by buying from other large holders, such as insurance companies, which receive stronger inflows when rates are high as their product pricing improves.
Seemingly predicated on the FOMC Minutes, rates began to rise (and underperform stocks):
- Several market participants and commentators interpreted the FOMC minutes as indicating a shortening of the duration of QE programs
- The Summary of Economic Projections revealed that those participants who had factored a continuation of asset purchases into their projections “were approximately equally divided” between those who expected a completion of purchases around the middle of 2013 and those who judged that purchases would be required to persist for longer
- Although we view the rise in rates following the release of the minutes as overdone, the treasury selloff has stoked concerns about the effect of rising rates on the US credit market
However, looking back at around 20 years of Barclays data, we find that spreads have never widened as rates rose
This relationship also generally holds over a longer time span. The only counterexamples occurred during periods of high inflation where equities sold off as well
Spreads Widen During Inflationary Risk-Offs
The 1970s-early 1980s was the only period in the past 90 years when credit spreads widened during interest rate increases
During that time, the U.S. economy went through several recessions, and inflation was at record highs
- Credit spreads spiked during the 1974-75 recession and the 1980-82 recessions, periods that corresponded with sharp increases in interest rates
- However, during each of those periods, equities sold off and underperformed credit dramatically, indicating that the credit sell-offs were reflective of generic risk-off sentiment and not a result of a rotation into equities and out of credit
Furthermore, any mutual fund outflows would likely be balanced by increased demand from insurance and pension funds
With the Fed buying, we find it hard to see how flows into credit could reverse course. And even when the Fed eventually stops, the continuing pattern of flows into credit during the current rising rate environment seem to make a “Great Rotation” unlikely
as outflows have tended to be short in duration and small in magnitude...
The historical analysis provides no example of a large-scale reallocation away from credit during periods of rising rates.