Equity markets have surged in early 2013 following the fudged temporary solution to the US fiscal cliff. Investor inflows into equity funds have also jumped. The Investment Company Institute (ICI) reported that US investors put $14.8bn into equity mutual funds in the week ending 9th January, the highest weekly inflow since 1997. So is this the start of the ‘great rotation’ from bonds back into stocks?
By way of context, US investors have sold an estimated $544bn of equity mutual funds over the past five years. While the sharp falls of 2008 were responsible for half this outflow, US investors have continued to sell equity mutual funds each year since, despite the continued recovery in stock markets. At the same time, investors have bought $1.08tr in bond funds, an estimated $300bn in 2012 alone.
Admittedly, this level of equity outflow is not as drastic as it might seem at first. These figures ignore the big shift in fund management – exchange traded funds (ETFs), which we use at Nutmeg as a liquid, transparent and cost-effective way of building portfolios. According to Lipper, investors put $222bn into US-domiciled equity ETFs over 2010-2012, offsetting around two-thirds of the outflow from mutual funds. However, it is still clear that the switch from equities to bonds as a primary savings vehicle has been very significant.
This trend is echoed here in the UK. Pension funds and insurers have continued to reduce equity holdings in favour of bonds over the past decade. In November the Pensions Regulator reported that the share of equities in defined-benefit pension schemes had declined from 41.1 per cent in 2011 to 38.5 per cent in 2012 – compared to 61.1 per cent in 2006. The proportion of bonds has risen from 40.1 per cent to 43.2 per cent – compared to 28.3 per cent in 2006. And while retail investors continue to buy stocks, bonds have seen significantly more attention. Over the first 11 months of 2012, retail investors bought a net £2.69bn of equity funds compared to £3.17bn in 2011, according to statistics from the Investment Management Association. Bond funds, on the other hand, received £5.54bn in the first 11 months of 2012, up from £4.47bn in 2011.
Overall, however, the data on investment flows over the past weeks does not give a clear impression that investors are switching en masse from bonds to stocks. The surge in flows into equities in 2013 so far only offsets the outflows in the final weeks of December.
So what will cause investors to switch? In many countries the yield on stocks is now comparable – or above – that on medium-term corporate bonds. In the UK both yield around 3.7 per cent. In the US the yield on high-grade corporate bonds is still 0.9 per cent above that of stocks, but this is the smallest premium since the 1960s. As a result, long-term savers seeking income may well prefer the potential of growing dividends, rather than investing in corporate bonds.
Secondly, many investors have missed the rise in stocks over recent years, but captured abnormal returns from bonds. With little prospect of further outsized gains on bonds and a very limited return on cash, equities are likely to find new buyers. We are not predicting a return to the so-called ‘cult of the equity’, but flows out of government bonds are likely to provide more impetus to the rally in stocks in 2013.
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