By Mathieu L’Hoir
In the current context, it is important to distinguish between two types of rotation. A trade rotation is marked by investors’ preference for risky assets in a risk-on environment following risk-off episodes. The aim is to opportunistically benefit from a declining equity risk premium and cheap valuations by making tactical adjustments.
A great rotation involves a larger move in investors’ strategic long-term asset allocations from bonds to equities. This ‘tectonic’ shift relates to such factors as long-term risk budgeting, the regulatory environment and monetary policy. One example of this is the significant change in pension fund allocation over the last decades, where their allocations to equities has declined in most countries and is now at historical lows.
Current market movements point to investor rebalancing of a tactical, rather than strategic, nature. The rotation we are witnessing is that of cash into equities, not from bonds into equities. The combination of accommodative monetary policy, declining risk aversion, rebounding economic activity, attractive valuations (at least for Europe and emerging Asia) and the expectation of rising yields bodes well for equity returns. But similar conditions existed in 2009 without triggering a corresponding great rotation, producing rather a trade rotation.
How are investors behaving?
Investors will need to see clearer signs of sustainable improvement in market conditions before altering their strategic allocations. Institutional investors, for the most part, are primarily focused on capital preservation. The current regulatory environment limits the flexibility of insurance companies and pension funds in terms of asset allocation. Regulatory changes such as Solvency II and Basel III encourage them to give preference to short-term and less volatile fixed income assets in their portfolios. This has resulted in a structural reallocation of insurers’ portfolios towards sovereigns and credit at the expense of equities.
On-going regulatory uncertainty makes them less inclined to make significant changes to their portfolios’ asset mix. Looking at pension funds with respect to their capacity to bear more risk, current funding ratios in large pension markets such as the Netherlands do not provide much more scope for increased exposure to risk assets. There are clear signs that a tactical trade rotation is underway. Within the equity universe, a tactical rotation by investors typically favours small cap over large cap, value stocks over growth, and cyclical over defensive sectors, high beta over low beta countries.
The investment implications
Considering the issue of trade rotation as delineated above, we believe investors should consider: including global small caps in portfolios to diversify equity exposure and benefit from the on-going trade rotation in small caps, with a preference for the US. Avoiding exposure to single style, whether growth or value, and instead adopt a selective approach straddling both value and growth universes. On a country level, it would be advisable to overweight emerging Asia and some European countries such as Germany. Emerging Asia usually outperforms during trade rotation periods.
Mathieu L’Hoir is senior equity strategist at Axa Investment Managers
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