The term “Great Rotation,” which came to prominence in late 2012, refers to the widespread prediction that record-low bond yields will prompt investors to rotate out of bonds and into stocks during 2013 and beyond. But is the Great Rotation a legitimate concern, or just another unfounded worry propagated by the financial media? The most likely answer: A little of both.
What is the Great Rotation?
The Great Rotation is a term coined by Bank of America Merrill Lynch in its research note from October 2012 titled “The Bond Era Ends.” In the piece, the authors laid out the case for why bond investors are likely to being rotating cash into the stock market – a trend that would boost equities but depress bond prices. The logic behind the Great Rotation is as follows:
1) Bond yields have fallen so far (as their prices have risen), that yields can’t fall much further. As a result, it’s inevitable that yields will rise (and prices will fall) in the years ahead.
2) Two important reasons for the decline in yields have been the “flight to quality” – as fear about various macroeconomic issues has prompted investors to gravitate to lower-risk bonds and away from stocks – and the Federal Reserve’s policy of ultra-low interest rates.
3) With the global economy gradually picking up steam and the major risk factors (such as the European debt crisis and the fiscal cliff largely removed from the equation, this flight to quality is bound to reverse in 2013. In addition, the Fed will eventually need to raise interest rates and end its policy of “quantitative easing,” events that would remove the most important pillars of support for the bond market.
4) With these issues in mind, and seeing more limited opportunities and unattractive yields in bonds, investors will rotate cash away from the relative safety of fixed income investments to take advantage of the reasonable valuations – and more attractive long-term total return prospects – in stocks. Since the 2010-2012 rally in bonds was driven in large part by massive inflows of investor cash, a reversal of these inflows would exacerbate the downturn in the bond market and lead to serious losses for fixed-income investors.
That’s the essence of the Great Rotation. And it’s an idea that gained a great deal of credence through late 2012 and early 2013, as evidenced by the flood of headlines devoted to the topic through the first quarter of 2013.
Is the Great Rotation a Legitimate Threat?
As in all things market-related, opinions are mixed. BofA, which popularized the term, believes the Great Rotation – while likely to be an uneven process – has already started. John Bilton, an investment strategist at BofA, says “Equities will become more attractive because they are geared to growth and offer returns that investors simply cannot get from their bond portfolios.”
At the same time, Tobias Levkovich, a noted strategist at Citibank, said (as reported by Business Insider), “We have heard some suggest that individual investors will exit the fixed income asset class once bond funds suffer losses, but we would remind readers that the tech bubble peaked in March 2000 and aggressive growth funds only began to witness consistent outflows in mid-2002; a full 26 months later. Hence, at the first sign of bond fund losses, we deem it doubtful that people will immediately give up on a 30-year bond rally.”
Put another way, don’t read too much into weekly and monthly fund flow data. With investors on edge in anticipation of the Great Rotation, every data point showing heavy inflows into stock funds and/or out of bond funds will be interpreted through that prism for now. The trouble is, there’s so much noise in short-term fund flows that such “analysis” is meaningless.
Further, the Great Rotation could be derailed by an unexpected slowdown in the U.S. economy, a revival of Europe’s debt crisis, adverse economic developments in China, or any other surprise that would cause investors to seek the relative safety of bonds.
In other words, don’t believe everything you read. While the upside for bonds is indeed limited at this point, making investment decisions on concerns about the Great Rotation isn’t advisable. Pundits are frequently wrong, and it’s rare for an event that has received as much attention as this one has to unfold exactly as the consensus expects. And in this case, it doesn’t hurt that the issue in question has been given a catchy name. As always, investors are better served by designing their portfolios to meet their own objectives rather than reacting to the headlines.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Be sure to consult investment and tax professionals before you invest.
