2nd April 2013
The current shift towards equities may not be a strategic great ‘rotation’ but a tactical ‘trade rotation’ Axa Investment Management is warning.
The fund manager says this trade rotation arguably favours investment in emerging markets, within Europe it may favour Germany and in global small caps with a US bias though it also says investors should aim to straddle both growth and value.
The case for this not being a tectonic shift
Mathieu L’Hoir, senior equity strategist, Axa Investment Managers says that the current shift may be because some investors are seeking to opportunistically benefit from a declining equity risk premium and cheaper valuations. But it does not necessarily represent a tectonic shift. Indeed, one example of this is the move by pension funds to shift long term allocations away from equities to bonds and that has not reversed.
In a note, L’Hoir says: “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.”
He argues that before investors alter strategic allocations, they will need to see a sustainable improvement in market conditions. He adds that most institutional investors are concerned with capital preservation and in the case of insurance companies and pension funds, they may not be allowed to change.
The note continues: “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 investment implications L’Hoir continues: “Considering the issue of trade rotation 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.”
“The decline in the equity risk premium is not yet reflected in current European equities valuation multiples, opening the door to a potential value trade rotation. Our valuation analysis suggests that German stocks are currently trading around 15% below the fair value implied by their fundamentals. The underperformance of value stocks both in the US and Europe could be a sign that value stocks are now significantly discounted, offering an interesting entry point to play a value-growth rotation trade through a re-rating of value stocks. However, the current discount of value stocks with respect to growth stocks is similar to what was experienced in 2007. The positive effect of a decline in the risk premium has been counter-balanced by the negative impact of the deteriorating economic environment on the earnings of value stocks.”