Monday, January 21st, 2013

The Great Rotation

Is this the great rotation? The opinion pages have been full of the shift back into risk assets, particularly equities into bonds. We first suggested this was about to happen in late November, and it is fast becoming the new consensus. So how long can it last? We never claim to have a crystal ball. We concentrate on the accurate description of the present rather than forecasting the future. Our view is that much of this rally in risk assets was driven by an increase in the volatility of government bond markets in the Q4 2012. If “risk-free” assets become riskier, the extra risk of investing in equities declines. For the time being it looks as though the volatility of bonds (US, UK and German) has stopped rising. This doesn’t mean that equities have to fall, merely that the impetus for further inflows is on the wane.

So far there are no major implications for equities versus bonds, but it does matter for our global equity allocation. Back in Q4 2012, the decline in bond volatility went hand in hand with a decline in currency volatility across all of the developed currency pairs. This has stopped and in the case of sterling (GBP/USD and GBP/EUR) it looks as though it has it has begun to reverse. Extra currency risk makes the UK equity market less attractive to overseas investors

The same thing will apply to most cross-border equity investment if currency volatility picks up across all the majors. For the last few months, there has been a welcome silence from politicians and central bankers on the subject of exchange rates. We wonder how long this can last in the face of such aggressive currency depreciation from the new Japanese government. If currencies become a hot topic once more, this will directly favour those markets with a large domestic investor base and a long history of home bias. That means the US, which is currently languishing close to the bottom of regional equity allocation. And so the wheel turns…

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