In addition to the "great rotation" taking place in investor mindsets, as the world - at least in theory - shifts away from monetary easing to fiscal stimulus facilitated by that other "great rotation" in the White House, a third such rotation is supposedly taking place in capital markets as investors dump bonds to buy stocks, i.e., a "great rotation" out of equities and into bonds, incidentally this is the 5th consecutive year when strategists have predicted such a trade is about to take place only to be soundly rejected. However, according to the latest analysts by Goldman's David Kostin who has shown a remarkable proclivity to using the jargon du jour, an imminent great rotation from stocks to bonds is not only not going to happen, but it is in fact, "fake news"
As he notes in his late Friday report, the political rotation occurring in Washington, D.C. will not be mirrored in financial portfolios: despite the sharp fall in bond values during the past six months and the prospect of further losses in 2017, Goldman expects minimal asset rotation away from debt and into equities for two reasons:
- Many categories of investors are restricted from allocating assets away from bonds.
- Investors such as pension funds and households that have latitude to shift assets have debt allocations that are currently at the lowest level in 30 years. Mutual funds may see a migration of assets from bonds to stocks, but the pace and magnitude of any rotation will be limited.
Here are the details behind Goldman's accusation:
Mirage of a great rotation from bonds to stocks
A great rotation is happening in Washington, D.C. as Donald J. Trump prepares to assume the Presidency. The dominant position of Republicans inside the Beltway has prompted investors to focus on prospective tax and regulatory reforms after years of partisan gridlock. During the campaign, the airwaves and social media were focused on “fake news” – misinformation, half-truths, and political spin.
In the realm of investing, an example of “fake news” is the claim by some market participants that a “great rotation” will take place from bonds to stocks. Despite a sharp rise in interest rates during the past six months and a drop in the market value of debt holdings, we expect minimal asset rotation away from debt and into equities during 2017.
Asset migration will not occur for two key reasons. First, funds must be sourced from one area before they can be re-invested in another. However, regulatory and policy restrictions limit the ability of many categories of investors to allocate assets away from bonds. Second, several investor categories have debt allocations that are currently at the lowest level in 30 years. Debt holdings of these investors may decline further, but a more likely outcome is that bond holdings and allocations remain unchanged and debt as a share of the portfolio falls only to the extent equities appreciate.
The Fed’s flow of funds analysis shows the US fixed income market totals $41 trillion encompassing US Treasuries, agencies, municipals, and corporate bonds (excluding loans). Foreign investors, financial institutions, the Federal Reserve, and insurance companies own more than 60% of the US debt market (see Exhibit 1). For context, the total US equity market totals $37 trillion (which includes $23 trillion in domestic public equity that is dominated by $19 trillion in S&P 500 equity cap).
Our credit strategists estimate that during 2H 2016 the market value of the Barclays US Aggregate Bond Index fell by $900 billion or 5% to $19 trillion from $20 trillion as interest rates rose by 94 bp to 2.4%.
Despite the plunge in debt values since mid-year, we believe asset migration away from bonds and into equities will be limited because many debt owners have restrictions on portfolio allocations. For example, the Fed owns $4.2 trillion of Treasury and agency debt, but no municipal or corporate bonds. No rotation will occur in the US central bank portfolio because it is not permitted to own equities. Similarly, insurance companies own $3.2 trillion of corporate bonds, roughly 70% of its debt portfolio, but risk-based capital guidelines impose a high cost to own equities and effectively deter any significant asset re-allocation out of bonds.
Investors with the ability to reallocate assets within their portfolios – such as households, pension funds, and mutual funds – own $13 trillion in bonds or roughly one-third of the $41 trillion domestic debt market.
Despite the sharp rise in interest rates during 2H 2016, mutual fund, pension fund, and household debt and equity demand largely followed the pattern of prior quarters. Mutual funds continued to sell equities and buy debt in 3Q 2016, which was consistent with the trend of equity mutual fund outflows and bond mutual fund inflows last year. Pension funds remained net sellers of US equities, following the pattern we have witnessed during the past seven years. Households is a residual for all ownership not otherwise classified and includes non-profits, endowments, and domestic hedge funds. Household debt and equity purchases sometimes swing sharply from one quarter to the next.
Our economists forecast the 10-year Treasury yield will rise to 3.0% by year-end 2017, which would further reduce the market value of debt holdings following a 100 bp rise in bond yields during 2H 2016. A 60 bp rise in bond yields to our year-end 2017 forecast would result in a $500 billion or 4% drop in the $13 trillion aggregate market value of debt holdings by mutual funds, pension funds, and households. If 10-year US Treasury yields rise by 100 bp to 3.4%, mutual funds, pension funds, and households would experience a $850 billion or 6% decline in the market value of their debt holdings.
Despite the potential for significant value destruction in bond holdings, we expect asset rotation will be limited. Debt accounts for 19% of household financial assets, close to the lowest level over the last 30 years. Pension fund allocation to debt is also close to the lowest level of the past 30 years, with Defined Benefit plans at 20% and Defined Contribution plans at 6% of total financial assets. We believe households and pension funds are unlikely to reallocate assets from debt to equity in the near-term (see Ex. 2-4).
Debt holdings by mutual funds accounts for 30% of total mutual fund assets, in line with the 5-year, 10-year, and 25-year averages. Mutual fund debt allocation peaked at 57% in 1991, but fell to a low of 18% at the height of the Tech bubble. Precedent exists for mutual fund debt allocation to decline from the current level and be a source of incremental demand for equities, but the pace and magnitude of any rotation will likely be limited.