A new investment theme began to gain traction from the end of 2012 and into 2013: Asian investors, particularly wealthy individuals, were going to embark on a huge rotation of their invested assets.
In particular they were going to dump bond investments that had made them a lot of money during 2012 and plough this capital into equities instead.
The idea seems logical. Bonds in Asia enjoyed a major bull run during the latter part of 2012 in particular, with the J.P. Morgan Asian Credit Index rising 14.3% over the year in US dollar terms, its best year since 2009, but yields were looking very tight by early this year.
And with the US economy looking solid, China earnings in the third quarter surprisingly strong and the eurozone finally looking as if it has hit rock bottom, the signs looked good for a rebound in equities.
There’s just one thing: the rotation hasn’t happened.
Equities have definitely regained a spring to their step. The Hang Seng Index has risen 4.6% to 22,771.44 since the beginning of December 2012 to March 7, the S&P 500 increased9.56% to 1544.26 and the Dow Jones Industrial Average hit a record 14,253.77 on March 5, above its previous high in October 2007.
But while stocks are back in fashion it doesn’t mean that investors have abandoned bonds.
“I wouldn’t say we’ve seen a marked shift of assets from fixed income into equities,” says Cecilia Chan, fixed income chief investment officer for HSBC Asset Management in Asia. “We have talked among ourselves as to whether we see any shift from fixed income into equities, but can’t see that this [assumption] is justified. In terms of our top discussions with investors, brokers and counterparties, [the consensus] feels that equity could become an attractive asset class while bonds are experiencing sideways movement.”
Chan notes that HSBC has seen rising demand for its equity funds, a few days of net outflow from its fixed income, but that on average the former has been rising and the latter largely flat.
It’s a message that is iterated by other asset managers and private bank representatives. “We are not seeing investors unwinding existing holdings in credit, but they are not adding to them either,” says John Woods, chief Asia strategist at Citi Private Bank.
Equities may be hot, but the money being ploughed into them is not coming at the expense of bonds. Instead the true rotation has been out of cash.
Looking West
During the course of 2012 many wealthy investors stayed very cash-long, as a mixture of US economic fragility, eurozone sovereign debt problems and slowing Chinese economic growth served to hurt expectations of economic growth.
Many investors kept sizeable chunks of their assets in cash for purely defensive reasons, worried that they would lose money by spending it. Bonds were also increasingly favoured, offering as they did a guaranteed return and the prospect of investors getting their entire principal back at some point.
“We have a roughly 35% weighting for cash and fixed income at the GIC [Global Investment Committee] but we were seeing weightings more than 10% over this for aggregate client holdings [in the latter months of 2012],” Woods recalls.
Towards the end of the year investor sentiment changed, largely courtesy of improving Chinese corporate earnings and the eurozone settling the risk surrounding its future (at least temporarily).
A more settled economic environment helped reassure investors that they could put more money to work. Asia’s high yield bond market was one of the immediate beneficiaries, and its performance quickly improved.
“A lot of the Asian bond market’s performance last year was a good old fashioned speculative bubble,” says Mark Matthews, head of research Asia at Julius Baer. “People realised the bond market was hot so they put in massive subscriptions knowing that they wouldn’t get much back. Now there is not that much left to chase, and clearly equities have returned to some degree so some investors have moved there.”
“We are absolutely seeing a rotation out of cash and rate products into equity and fixed income credit,” says Woods. “Last year our clients were overwhelmingly overweight cash and rates products. But last quarter that proportion started to diminish in favour of risk, loosely meaning equity and credit.”
But this move towards equity has not necessarily been into Asian equities. In fact while the region’s stock markets have benefited from resurging interest, particularly from domestic retail investors in North Asia buying local, high net worth individuals have been instructing their bankers to go west.
“Over the last six weeks we’ve seen a preference for developed market equities, particularly dividend-paying ones,” says Woods. “Clients are still cautious of Asia equities and generally much more comfortable with large blue cap dividend paying stocks in the US and Europe.”
He believes the reason for this is good old fashioned caution. “I’d guess the preference for US and European investments reflects a level of caution to high beta markets, especially in Asia. In North Asia we see a strong home bias but across the broader Asian markets we see an investor preference for more defensive developed market names. Our clients are not out and out risk takers.”
The big question is whether there is enough momentum to maintain the flow of funds into equity markets. Grace Tam, a market strategist at J.P. Morgan Asset Management feels that it will take another piece of good news for the markets to keep rising as they have of late.
“What we lack now is a new catalyst,” she says. “For the past three or four months the rally was basically over diminishing risk around the European crisis and a Chinese recovery, but that’s all priced in now. People need another catalyst to support further gains in equity market.”
Enduring debt
The cautious attitude towards stocks reflects some painful lessons of the past two years. Equities have long found favour in the region, but many of the region’s stock markets had a poor run during this period. In contrast the robust returns offered by bonds have offered some compelling reasons to expand investment horizons.
Diversification, in other words, has finally become an accepted investment philosophy. And this, combined with lingering uncertainties about the world’s economic climate, has left the region’s wealthy unwilling to start relinquishing the bond investments that have served them so well. Add into this the growing pool of institutional funds that have to invest in bonds, and it makes sense why cash hasn’t poured out of debt investments.
“The argument about this asset rotation is missing one important fact, and that is that there is a massive universe of investors who cannot and will not own equity because it’s too volatile, or their investment mandate won’t allow them to buy it,” says Matthews. “There is a large pool of money that will always buy bonds, because they offer the yield without the volatility of equity. Equities have dividends that approach the yield of bonds but they are far more volatile.”
J.P. Morgan Asset Management’s Tam also sees a strong investor bid continuing to exist for high yield debt.
“Investors have not totally given up their fixed income phase; we still see strong flows into emerging markets and high yield bond funds,” she says. “I think people are trying to shed some bonds in favour of equities, but the income or yield theme is still happening.”
While bonds have already enjoyed some strong performance Matthews notes that the market can still offer a compelling steady reward for those able to stomach some risk.
“There are still many picks in the bond universe where you get a coupon that is very good. So even if you don’t enjoy any capital appreciation you’re still getting 5% to 7% [a year] and you know that in all likelihood the price of the bond will go to 100 and you’ll get it back. You don’t have that certainty with equity.”
In truth the largest threat to bond performance may not be the equity performance but the world’s interest rate outlook.
“People are not underweight globally in equities but in cash. They’ve been taking money out of bank accounts and putting it into bonds,” says Matthews. “However were you to see an improvement in the US economy and this takes away the Federal Reserve’s liquidity efforts, and interest rates begin rising, it’s likely that they would begin to put some of this money back into bank deposits. A lot of people have been forced into bonds because they don’t get interest on their bank accounts anymore.”
This isn’t likely to happen soon. Federal Reserve (Fed) chairman Ben Bernanke underlined his commitment to maintaining quantitative easing on February 27, and there’s little chance of rates rising until 2015. Matthews says that the sweet spot for investors to stay in bonds is for US gross domestic product growth to remain around the 2% area.
“Under 1% you would have worries about corporate defaults while over 3% there would be worries that the Fed takes the punch bowl away,” he says. “But we don’t see 3% growth right now, and the corporates have so many liquid assets on their balance sheets.
A balanced approach
Cautious optimism is probably the best way to describe the mood of the average private bank client now. High net worth individuals believe that the worst of the world’s economic uncertainty is behind them, and that the future may be bright.
But they continue to have sufficient ongoing uncertainty to be unwilling to go all-out, in full risk-taking mode, hence their preference for safe, blue-chip stocks in the US and Europe, and the desire to hang onto decently yielding bonds too, even if they are unlikely to enjoy much more beta performance.
It’s a scenario that looks like to continue this year, with slowly increasing bouts of optimism occasionally punctured by the odd piece of bad news.
“This year looks likely to be similar to last year in terms global growth and investor risk appetite,” predicts Citi’s Woods. “You may recall we began 2012 on a strong note after the LTRO [the European Central Bank’s long term repo operation in December 2011, in which it began offering unlimited sums of money to avert a credit crunch] and gave these returns back in the middle part of the year. Elements like the European crisis have been kicked so far down the road that they’re out of sight: that doesn’t mean that they have gone away.”
It’s not an environment that is likely to quickly create the asset rotation that has been discussed. Bonds may not offer quite the possible appeal of equities, but equally they are useful defensive instruments to have in what remains an uncertain environment. And equities themselves are more likely to appeal on the developed world, where earnings per share look far more impressive than in Asia.
Stocks are once again in high net worth individuals’ asset mix, but a lot more will have to go right for them to begin siphoning money off from bonds in any meaningful manner.
Until the world’s economic outlook gets clearer, Asia’s great asset rotation looks set to remain a myth.