The 2008 meltdown is finally in the rear view mirror. The global economy has moved on.
But the current market rally is driven largely by the growing sentiment that the worst is over: America has not gone over the fiscal cliff, the Eurozone has not split, China has not had a hard landing, and the price of oil has not spiked despite the unrest in the Middle East.
Previous rounds of quantitative easing in Europe and the U.S. have prevented all-out deflation. The latest round is the most potent. Markets have struggled to shrug it off.
Equities are set for a bounce. They look attractive relative to bonds. But the ice age for equities will thaw only when economic fundamentals begin to look stronger and more sustainable. The much-predicted stampede out of bonds will occur later rather than sooner – if there is one. Interest rates will edge upwards as the real economy improves. But that won’t happen anytime soon.
In fact, the current rhetoric of sector rotation – from bonds to equities – is overblown. It assumes that investors are faced with simple binary choices: risk-off vs risk-on, or bonds vs equities. This is too simplistic.
The reason is that investors do not have identical risk appetites. The 2012 Principal Global Investors/CREATE global survey – Market Volatility: Friend or Foe? – showed that the reality is far more nuanced. In successive rallies since the 2008 market collapse,
- 5% of investors have been ‘adventurists’ who believe in contrarian investing and market timing amid turmoil.
- 35% have been ‘pragmatists’ who believe in portfolio rebalancing when momentum is working.
- 40% have been ‘purists’ who believe in buy-and-hold investing and see volatility as a risky game.
- 20% have been ‘pessimists’ who lost a bundle in the last decade and can’t wait to exit at an opportune moment.
Furthermore, investors are not faced with identical circumstances. For example, pension plans are caught between a rock and a hard place. They know that current bond values are unsustainable in the medium term, but their liability profiles favor bond investing, in the face of ageing demographics.
Many of them have adopted dynamic LDI (liability-driven investing) programs to progressively immunise risk via bond investing, as part of sponsor covenant. Most of them are unlikely to backtrack.
Notably, the recent new money flowing into equities has not come from bonds. If anything, flows into bonds remain healthy. Rotation will gain traction when the economies in the West shift the needle on output and unemployment. As yet, this is not evident outside the U.S. Growth engines in Europe and Japan are few and far between.
The United States may well end up being the locomotive that pulls the rest from their current quagmire, though that may take time. Markets will improve, but they will follow a jagged trajectory until the end-game of QE is clear.