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Great rotation theory is misleading, says strategist

04 April 2013

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The term 'great rotation', where institutional asset allocations are switched from bonds to equities, is misleading and there is little evidence to support it, said a strategist from Legal & General Investment Management (LGIM).

A number of factors, which have contributed to a shift into bonds, have not changed, so there are not many reasons to expect a widespread reallocation from bonds into equities, said Lars Kreckel, LGIM global equity strategist.

Instead, Kreckel argued at the LGIM Fundamentals briefing that a 'slow rotation' is expected, where there is a rebalancing of flows rather than a great rotation.

"After a decade of investors reducing exposure to equities and increasing bond holdings, it is a tempting theory that this will somehow go into reverse, providing a decade-long tailwind for equity markets," said Kreckel.

"However, closer inspection reveals the conditions that caused funds to flow into bonds have not changed."

The great rotation theory states that record-low bond yields will prompt investors to rotate institutional asset allocations from bonds into equities. Kreckel said there are signs of an investor rotation into equities, but there are no outflows from bonds yet.

According to data from LGIM, since late November 2012 equity inflows have been greater than bond inflows for the first time since 2010, but it is too early to call it a trend, and it is more likely a reflection of a growing risk appetite than a fundamental asset rotation. Kreckel said the marginal new investment dollar is likely to go into equities rather than bonds.

"We don't believe that any optimism around equities needs acceptance of the great rotation argument. In fact, our research shows that historically, positive flows have not been required for equity markets to rise – it is other factors that will drive markets higher," said Kreckel.

There are certain triggers, which drove investors into bond markets that have not changed.

Although equity valuations are favourable, Kreckel said valuations have not been reliable catalysts for asset rotation, and that valuation is not generally a good timing tool.

Among a number of triggers, inflation would have to rise as record-low bond yields do not offer protection against a scenario of rising inflation, and bond returns would have to be significantly negative in order to accelerate the great rotation process.

There would also have to be a change in pension fund regulations. For example, there are high capital charges for equity investments under Solvency II, which means that asset allocations are more favoured towards bonds than equities. Also, demographics will remain a factor favouring a greater bond allocation.

Kreckel said these factors are unlikely to change in the short-term, so it is unlikely that a great rotation will take place.

Even though there is scope for fund flows to move into the equity market, evidence suggests that there has been a decline in equity allocations within pension assets in the UK and at a global level.

Data suggests that globally there has been a rotation out of equities and into alternative assets, such as private equity and hedge funds, rather than into bonds. Kreckel said this demonstrates diversification rather than just simply a great rotation.

He said: "The old stamp of 2000 or the late 1990s is probably not the new norm, which we are truly aiming for. There are simply many more asset classes that are available today."

First published 04.04.2013