Beginning of a ‘Great Rotation’?

Joe PreisserJoe Preisser, Brinker Capital

As the share prices of companies listed in the United States rose this week, to heights last seen in October of 2007, speculation has run rampant that a so called ‘Great Rotation’ from fixed income to equities may have commenced.

The continued easing of Europe’s sovereign debt crisis, combined with positive corporate earnings surprises and the temporary extension of our nation’s borrowing limit, has helped to quell a measure of the uncertainty that has plagued market participants during the course of the last few years. Tangible evidence of this phenomenon can be found in the marked decline of the Chicago Board Options Exchange Market Volatility Index (VIX), commonly referred to as the “fear gauge”, which is currently trading far below its historical average. The steep drop in expected market volatility suggests that investors believe to a large degree that many of the potential problems facing the global economy are already priced into current valuations, and as such have set expectations of the possibility of any external shocks to be quite low. This state of affairs has led directly to an increased appetite for risk within the market, which has culminated in strong inflows into equity funds. According to the Wall Street Journal, “For the week ended January 16, U.S. investors moved a net $3.8 billion into equity mutual funds. That followed the $7.5 billion inflows in the previous week, along with another $10.8 billion directed to exchange traded funds. Add it up and you’re looking at the biggest two-week inflow into stocks since April 2000” (January 24, 2013).

Although the movement of money into equities this year has been quite strong, whether or not this is the beginning of a significant reallocation from fixed income remains to be seen. Despite the flight of dollars into stocks, yields, which move inversely to price, on both U.S. Treasury and corporate debt have risen only moderately, and bond funds this year have not experienced the type of drawdowns that would be expected if investors were truly rotating from one asset class to another. In fact, what has transpired speaks to the contrary, as although inflows to the space have slowed from last year, they remain robust. According to an article in Barron’s published this week, “Bond funds, meanwhile, attracted $4.63 billion in net new cash. Bond mutual funds collected $4.21 billion of that sum, compared to the previous week’s inflows of $5.45 billion” (January 18, 2013). One possible explanation for the hesitation to exit the fixed income space is the lingering concern among investors over the looming fiscal fight in Washington D.C. and the potential damage to the global economy if common ground is not found. According to a recent Bloomberg News survey, “Global investors say the state of the U.S. government’s finances is the greatest risk to the world economy and almost half are curbing their investments in response to continuing budget battles” (January 22, 2013).

If begun in earnest, a rotation by investors from fixed income to equities would certainly present a powerful catalyst to carry share prices significantly higher; however caution is currently warranted in making such an assertion, as a potentially serious macro-economic risk continues inside the proverbial ‘beltway’. If the budget impasses in the United States is bridged in a responsible way, and the caustic partisanship currently gripping Washington broken, the full potential of the American economy may be realized and this reallocation truly undertaken. David Tepper, who runs the $15 billion dollar Apoloosa Management LP was quoted by Bloomberg News, “This country is on the verge of an explosion of greatness” (January 22, 2013).

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