big debate in financial circles in recent months has revolved around the so-called Great Rotation. Coined by Bank of America Merrill Lynch, it refers to a widespread prediction that record-low bond yields will prompt investors to rotate out of bonds and into equities. With both the Dow Jones and the S&P 500 reaching record highs, the theory seems to be gaining traction.
But the amount of market chatter about the Great Rotation is misleading. It is also somewhat exaggerated, perhaps in the same way as talk of the Currency Wars was. That is not to say that we won’t be seeing fund flows moving in the direction of the equity market, but we won’t see a massive asset reallocation from bonds into equities.
There is certainly scope for equities to significantly outperform fixed income, and that would represent a great rotation in the performance patterns of the last decade. And there is also scope for outflows from equities to end and to gradually reverse, as investors are pulled towards attractive yields and performance. A new investment dollar is now more likely to go into equities than into bonds.
But a great rotation of institutional assets – which in the UK, according to the Investment Management Association, make up around 80 per cent of the total – seems unlikely unless investors are not only pulled into equities, but also pushed out of bonds. And this will only happen either through painful losses, or through changes to pension fund and insurance company regulations.
A look at the statistics gives some flesh to the argument. In research carried out by Legal & General Investment Management, over a 20-year period UK pension fund allocations to equities have fallen from 60 per cent to 25 per cent, with allocations to bonds increasing from 20 per cent to 40 per cent. There is little to suggest that this will change. As the membership of pension funds mature, portfolios will become more bond-heavy as they move to reduce risk and aim for income. In the last 13 years alone, we have seen $575bn (£378bn) leave equities while $950bn has flowed into bonds. Numbers don’t lie.
This trend is not solely true of the UK. Global pension assets have shown the same decline in equity allocations. Funds are not flowing into bonds, but into alternative assets, including private equity, hedge funds, infrastructure and commodities. Take Caisse de Dépôt, which manages public pension plans in the Canadian province of Quebec. It is reported to be significantly reducing its fixed income allocation, and is redeploying the funds into less liquid assets like private equity, real estate and infrastructure. Cases like these support estimates that weighting in alternative assets will change from a quarter today to a third.
All of this reinforces the idea that the Great Rotation is a misnomer. While a great rotation in relative performance trends is likely, the great rotation of institutional asset allocations is not. There is room for slightly higher equity allocations from extreme lows, but pre-2000 levels are not a realistic target.
Lars Kreckel is global equity strategist at Legal & General Investment Management.