Rotation into Equities, or perhaps not just yet?
Markets started the year in a positive mood, and commentary from analysts and asset managers has highlighted the hope, even expectation, that 2013 will see the start of an all-round recovery. But some are warning it is too early to call a “great rotation” from more defensive holdings.
The latest monthly asset allocation survey by Bank of America Merrill Lynch of fund managers who collectively run $754bn of assets, revealed the highest level of equities in their portfolios since February 2011, with a net 51% of investors overweight the asset class.
Analysts have already dubbed it the ‘great rotation’ of 2013. Managers’ confidence in the global economy also reached its most positive level since April 2010, according to the survey.
As well as snapping up equities, the survey found managers were cutting cash holdings. The average fund manager now has 3.8% in cash, down from 4.2% in December. Bank of America Merrill Lynch said this was the lowest cash position since April 2011.
Michael Hartnett, chief investment strategist at BofA Merrill Lynch Global Research, said sentiment surged following the resolution of the US fiscal cliff. “Half of investors now tell us that they would sell government bonds to buy higher-beta stocks, which is consistent with increasing growth and inflation expectations, and with our call for a ‘Great Rotation’ to start in 2013.”
The survey found 49% of respondents expect government bonds to be sold to fund purchases of higher beta equities and sustain the “risk on” rally. This is up sharply from 37% last month. Within equities there are also some sectors fund managers expect to soar in 2013.
However, Russ Koesterich, BlackRock’s chief investment strategist, warned investors to be cautious. “In our view, the rally can be attributed to three factors, the first two of which are likely to be temporary,” he said.
The first is the relief over the US “fiscal cliff” deal. By the end of 2012, investors had become increasingly nervous over the fate of the fiscal cliff and were selling off stocks. Given that the January 1 deal averted a worst-case scenario, some of these same investors have moved back into the markets.
“We also saw some investors selling winning investments in December in an attempt to generate capital gains in 2012 before capital gains taxes were scheduled to increase in 2013,” he noted. “Because capital gains rates did not change for most Americans, however, many investors are now buying back the stocks they had sold.”
Secondly, stocks are benefitting from a normal period of seasonal strength.
While the so-called January effect may not be as significant a trend as some would believe, there is a modest historical tendency for stocks to advance in the first month of the year,” Koesterich explained. “This year, we have been seeing inflows into equities, with much of the money moving into higher-risk areas of the markets and into emerging markets equities in particular.”
The third factor is that economic data has been better than expected, not just in the US, but globally. Manufacturing data from China is confirming that an economic hard landing has been avoided and there are also positive signs from the US financial services sector.
Even given that positive momentum, the question now is whether the equity rally will be sustained or fade.
“For the year as a whole, we would expect equity markets to continue to advance and to outperform bonds, with the best performance likely coming in emerging markets. However, we expect the current pace of gains to slow, if not immediately, then probably by February,” Koesterich said.
There are several reasons to be at least somewhat more cautious in the near term. He expects further headwinds from the continued “dysfunction” in Washington as lawmakers wrestle with the debt ceiling, scheduled spending cuts and the need for continuing budget resolutions.
Not only are the odds of some sort of “grand bargain” diminishing, but the current bickering raises the possibility of another last-minute showdown and a potential debt downgrade.”
There is also political risk coming out of Europe, with Italian elections coming up in February. Should the election fail to produce a clear result, or should the voters choose a less market-friendly government than the one currently headed by prime minister Mario Monti, markets would likely react negatively, he added. “…Although these risks are clearly evident, investors seem to be overly complacent.”
One way this can be measured is by looking at market volatility. The VIX Index fell last week to its lowest level since June 2007.
To us, this suggests that there is not much bad news priced into market right now, meaning that any negative shock would have the potential to drive markets lower. The bottom line is that while we think stocks are reasonably valued (particularly outside the United States), we would expect tougher going as we head into February.”