The market is waiting for the "great rotation" to take place as if it is waiting for "Godot", the tragicomedy masterpiece by Samuel Beckett about two main characters, who wait in vain for the arrival of a mysterious personality named Godot.
The great part of this masterpiece's success is the fact that it was open to a variety of readings and interpretations. In today's financial markets, Godot is an allegory of the present situation, where investors wait and worry about an imminent end of the multi-year bull trend in the fixed income markets, which would reverse in a so-called "great rotation".
It is too early to declare a secular shift in equities, because for a rotation to happen, investors will need to be "pushed out" of the bonds and "pulled in" the equity markets. This rotation would only start when we see concrete signs of rising growth expectations and speculation about the end of monetary easing measures.
In the aftermath of the 2008 financial crisis, policymakers have undertaken drastic measures to stimulate the economy and avoid the effects of a systemic crisis. Central banks have, thus, embarked on a journey of quantitative easing rounds to help stimulate the lack of demand and revive the markets by reflating asset prices.
They have expanded their monetary base and created some inflation hoping for a gradual erosion of the excess of debt by purchasing short and long dated bonds. Interest rates have been therefore kept artificially low at both ends of the yield curve leading to a reduction in risk premium and an increase in issuance of high yielding assets.
In fact, the extra liquidity created through the quantitative easing rounds has created an extra incentive for issuers to use record low yields to raise leverage and for investors to search for higher yielding opportunities.
Post-crisis growth trends
From an issuer perspective, the rise of leverage did not result in a significant worsening in credit metrics: balance sheets are in a good shape and net debt-to-equity ratios have risen, but are still below historical average as most of the companies are issuing debt to buy back their shares.
For instance the net debt-to-equity ratio for MSCI Europe is at 56% near 2005 lows. Whereas, the interest coverage ratio has only slightly deteriorated as companies are replacing higher-with-lower yielding debt and earnings are not yet falling.
From an investor perspective, in a move favoring carry and principal protection, the appetite for fixed income assets has been clearly one of the most visible post-crisis developments. A trend which is still evident since the beginning of the year as investors have shrugged off their risk aversion investing more than ever in emerging markets and high yield debt.
Both segments have developed significantly in the past years turning into legitimate asset classes that are larger, better established and less risky than in the past. On one side, the universe of the emerging market corporate debt has surpassed the USD 1 trillion thresholds at the end of 2012, with an increasing contribution from the high yield segment (circa 40% of emerging markets issuance in Q1 13 vs. 27% during 2012).
On the other side, the high yield market has matured since the excesses of the 1980s and the early 1990s when its default rate reached 15% and offers today a compelling return to the right investor. Even though a double-digit return will be hardly achievable this year, the high yield market still holds its income appeal and the spread cushion argument during rising-rate cycles. In fact, during the four periods of rising rates since 1988, high-yield bonds outperformed high quality bonds by 1.59% on average and outperformed US Treasuries by 3.02 % on average.
Given that high yields' appreciation is built on prospects of an improvement in the fundamentals of the companies and their future growth, this segment has the ability to perform like stocks. Alternatively, equities derive their cues from their bond counterparts.
The road to equities
History has proven that the high yield market leads equity: new lows in high yields aim at new highs in equity levels. If we compare the BofA Merrill Lynch High Yield Master II Index to the S&P 500, high yields and equities have moved in the same direction in 77% of the years since 1987.
Appetite for high yielding assets is still significant as investors remain more than ever on a risk-on mode. In fact, in the past 3.5 years, inflows into high-yield bond funds have been quite spectacular exceeding those for the prior 20 years combined. Funds flows can give us good insight if a great rotation is underway from bonds into stocks.
Since the beginning of the year, net inflows into equity markets have been observed but this move has not yet come to the detriment of net outflows from fixed income markets. The first quarter of 2013 was the best since 2004 for US stock funds which have pooled inflows of more than USD 22 billion.
Still, during the same period, the inflows in bond funds have topped all asset classes for the 20th consecutive month. On the contrary, money market funds saw important outflows year-to-date which reinforces the fact that if a rotation would happen, it would affect low yielding instruments first.
Middle East's love for bonds
In the Middle East, a rotation out of bonds into equities has not yet materialized and is not expected in the near term. In the first quarter of 2013, equity markets have started to recover from the weak sentiment which was dominant between 2009 and 2012.
Primary market activity has started to pick-up with two IPOs launched in the Kingdom of Saudi Arabia and one in Iraq for a combined amount of USD 1.6 billion. The revival of the domestic economies, an improving market sentiment in the secondary markets and a boost in regional government privatization plans would be key drivers going forward for stronger IPO activities.
So far, encouraging signs are building up with a return of liquidity and signs of global investors' interest in the "cheap" Middle East stock markets. Year-to-date, the Dubai Financial Market General Index (DFMGI) was the best performing equity index globally and this rally moved hand-in-hand with the regional bond market. In fact, the Middle East high yield corporate bond market had the best performance among global peers with a total return estimated above 5.20% led principally by the Dubai Inc complex.
We can wait for the "Godot moment" indefinitely or "we can come back tomorrow". So far, the great rotation has not proven to be a legitimate threat for the bond market.
Too much focus has been given to this issue, investors may rather rethink their portfolios positioning in the current environment to generate returns while keeping a close eye on rates. Investors should find the right balance to navigate between a challenging combination of macro-driven volatility and the right investment product suitable to their specific risk-return profile.
Source: Strategic Insights, Morningstar, BofA Merrill Lynch, Ernst & Young, JP Morgan
Christiane Nasr is director and senior investment advisor for the Middle East at Credit Agricole (Suisse) S.A.
© Zawya 2013
