February 28, 2013 / 9:41 PM / in 5 years

SAFT ON WEALTH-Great Rotation a myth but stocks still a top pick

By James Saft

Feb 28 (Reuters) - Don’t hold your breath waiting for that Great Rotation out of global bonds and into stocks. Even so, go into stocks anyway if you are big enough and tough enough to survive the inevitable volatility.

The idea that investors will soon start to move much of the cash they’ve plunged into very low-yielding but safe government bonds into stocks is intuitively appealing. After all rates have to rise some time and the 30-year-plus bond bull market is looking long in the tooth. It also makes intuitive sense given the likelihood of lousy inflation-adjusted returns, even losses, in bonds.

The only problem is the world is brimming with old people, rickety banks and foreign central banks, all of whom want and need safe assets almost without regard to the price.

The upshot: equities will likely outperform bonds over the medium and long term but returns will be low by historical standards.

Behind the Great Rotation theory is a fear that when central banks begin to unload their government bonds, private investors will bail out, too, driving interest rates up. That will kill portfolios with heavy bond exposure - and there are a lot of them.

Don’t bet on it.

“Structural demand for safe havens is likely to remain high and, when combined with the structural scarcity of such assets, is likely to keep interest rates on safe assets low,” economist Michael Gapen wrote in the annual Barclays Equity Gilt Study, a long-running series on asset markets and returns.

Safe assets are, usually, government debt, which rarely default and are easily bought and sold even in times of distress or market dislocation. One of the ironies of the financial crisis is that even though government debt is objectively more risky now, demand is higher.

That’s because, in part, if the safest assets are riskier you need more of them in a mixed portfolio to have the same absolute level of risk. It’s also because a lot of assets which were created and bought as “safe” before the crisis - such as asset-backed securities - proved to be anything but.

By the loose definitions of 2007, safe assets equaled about 35 percent of global GDP in 2007. Take out all the faux-AAA debt and now that figure is nearer 25 percent, and expected to shrink in the coming decade. Less supply and more demand equals high prices.

Figure in that much of the world’s wealth is controlled by people in or approaching retirement, and you have a recipe for strong demand for government bonds, even amid a deteriorating longer-term outlook for government finances. After all, savers eventually want to eat their assets, and very few have assets large enough to accept much equity volatility late in life.

As well, new banking regulations being rolled out will force financial companies to hold many more safe assets, a huge source of demand. That process has years to run and will help to keep rates low.


Barclays thinks bonds will still do poorly over the next five years, with safe-haven bonds losing about 2 percent a year when you take inflation into account. Even though demand will be strong, economic growth, and some inflation, will eventually return, eating away at bond values.

Stocks will outperform by 5 to 6 percentage points annually, but that still only implies a 3 to 4 percent real return.

The gap between stock and bond returns - called the equity risk premium - is about at the historic average, but absolute return on equities will be low. Returns on a mixed portfolio will be even worse, perhaps no more than 1.5 to 2.0 percent annually.

For opportunistic investors it makes sense to be aware of the implications of this. I’d be very wary of companies with big pension fund deficits. Those are only going to get worse. I would also worry about the effect that this will have, over five or 10 years, on consumption and savings. There are still good reasons for savings rate to go structurally higher, and that means less money flowing around the economy, and, theoretically, still lower returns on stocks and bonds.

Still, the best advice is to take the best choice in a bad lot: equities. This is especially true for younger investors, who may want to consider keeping bond allocations lower than is usually recommended.

If you are going to lose 2 percent a year on bonds, and maybe about the same on corporate bonds, the less “safety” you can afford, the better off you will be.

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