Will the great rotation really take place now?
The phrase “the great rotation” was originally penned by an economist at Bank of America Merrill Lynch in 2012 when it was being predicted that the record-low bond yields would prompt investors to rotate out of sovereign bonds and into shares.
Bond yields in the US had dropped to record low levels at the time following the aggressive monetary stimulus measures in the aftermath of the bankruptcy of Lehman Brothers. Many analysts had been expecting a decline in bond prices (a rise in yields) in anticipation of the slowdown of the quantitative easing programme and eventually the end of emergency measures by the Federal Reserve.
In fact, the US 10-year bond yield rose by more than 100 basis points in 2013 during the easing of the bond-buying programme (referred to as the “taper tantrum”) as investors anticipated an end of the quantitative easing programme and an eventual increase in interest rates. However, after a brief period, yields declined once again (bond prices strengthened) as a result of various global developments and dropped to fresh record-low levels during summer 2016 as the Federal Reserve delayed additional interest rate hikes following the first increase in interest rates in December 2015 after a nine-year period.
Following the recent election of Donald Trump as the next US President, yields have rallied in anticipation of higher inflation due to the fiscal stimulus measures being contemplated.
In view of the resultant sell-off across the bond markets, the notion of the ‘great rotation’ out of bonds into shares is once again among the investment themes being contemplated. The international media this week highlighted that the US investment bank Morgan Stanley wrote about the great rotation in its latest global strategy outlook.
Some analysts are noting that although this investment strategy was not successful when it was first highlighted several years ago, the situation may indeed be different now due to concrete evidence of stronger economic growth in the US and low unemployment levels which will inevitably result in a rise in official interest rates by the Federal Reserve. Moreover, for the first time since the international financial crisis, there is a shift towards fiscal expansion which will result in higher government borrowing and consequently higher inflation indicating that the era of ultra-low yielding bonds is really coming to an end.
The decline in bond prices across the US and the UK was also felt across Europe with the 10-year German bond yield rising from a record low of -0.20 per cent in October to above +0.35 per cent this week. As I explained in my article two weeks ago, these developments were also reflected in Malta with the prices of the medium and long-term Malta Government Stocks dropping heavily since early November.
Will this also lead to “the great rotation” taking place in Malta too?
Since many local investors have never truly experienced a bear market in bonds, they find it difficult to dispose of a number of securities providing a regular flow of income and instead retaining a high level of idle cash, notwithstanding the fact that the disposal of most of the MGSs would represent earning several years of interest upfront due to the high premium over par value. The sell-off in the MGS market in May 2015 and the subsequent recovery to fresh record levels between the end of 2015 and October 2016 is still very fresh in investors’ minds, prompting several individuals to claim that this may indeed happen again in the months ahead.
However, following the sharp downturn in MGS prices in the aftermath of the US Presidential election and the heightened volatility from one day to the next, some investors are indeed reducing their high exposure to the MGS market to protect the extraordinary gains generated over recent years.
Some continue to favour a sustainable income stream and are going for a higher exposure to corporate bonds via the secondary market. Others, especially those who are accustomed to participating only at the primary market stage when bonds are generally issued at par value (100 per cent), do not look favourably towards acquiring bonds on the secondary market due to the premium in the price. In view of the changing dynamics and the significant increase in the number of investors applying at the primary market stage, investors should become more proactive and manage their investment portfolios regularly. Investors must become accustomed to using the secondary market since at times better yields are obtained than those on the primary market.
Elderly investors who have regularly invested in MGSs over the past 25 years would naturally be reluctant to follow the notion of the great rotation and take an exposure to equities. However, in recent years, there has been an increasingly larger amount of investors who entered the MGS market purely for speculative purposes. The gains made over recent years were truly extraordinary. However, such investors need to understand the factors that contributed to such strong capital gains and the changing international dynamics which are likely to prohibit similar gains to regularly materialise again in the future.
For those investors who accept repositioning their portfolio and consider a wider allocation to corporate bonds and local equities, a number of new investment opportunities are rumoured to be in the pipeline during 2017.
On the bond market, the coupon on new upcoming bonds will continue to be a major determining factor. Following the jump in the yield on the 10-year MGS which a few days ago reached over 1.35 per cent from a low of 0.83 per cent on October 24, 2016, retail investors need to benchmark the upcoming bond issues against this yield to gauge whether the new bond on offer adequately compensates investors for the additional credit risk when investing in corporate bonds. Future bond issuers therefore need to be more attentive to movements in international and local yields prior to the pricing and the launch of their bond issue.
The various fiscal incentives proposed by the Minister of Finance as part of the 2017 Budget will hopefully also lead to a revival of new issues on the equity market. The extension of the trading session on the Malta Stock Exchange as part of the National Capital Markets Strategic Plan should also help provide more depth to the local capital markets.
The Malta Stock Exchange is likely to extend the daily trading session to 3pm by mid-2017. This will enable a larger number of investors to regularly participate on the secondary market.
Another important development that can lead to a more active equity market would be the amendment of the free float requirement. At the MSE awards dinner last week, the Minister of Finance announced that the free float issue was being discussed with the regulators.
The amendment of the listing requirements to take into consideration the size of prospective issuers compared to the investment profiles of local investors would undoubtedly lead to many more local companies considering the capital market route.
The various initiatives mentioned should provide the necessary framework for a deeper capital market. This would then enable investors to also consider the great rotation in Malta too.
Rizzo, Farrugia & Co. (Stockbrokers) Ltd (RFC) is a member of the Malta Stock Exchange and licensed by the Malta Financial Services Authority. This report has been prepared in accordance with legal requirements. It has not been disclosed to the company/s herein mentioned before its publication. It is based on public information only and is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. The author and other relevant persons may not trade in the securities to which this report relates (other than executing unsolicited client orders) until such time as the recipients of this report have had a reasonable opportunity to act thereon. RFC, its directors, the author of this report, other employees or RFC on behalf of its clients, have holdings in the securities herein mentioned and may at any time make purchases and/or sales in them as principal or agent, and may also have other business relationships with the company/s. Stock markets are volatile and subject to fluctuations which cannot be reasonably foreseen. Past performance is not necessarily indicative of future results. Neither RFC, nor any of its directors or employees accept any liability for any loss or damage arising out of the use of all or any part thereof and no representation or warranty is provided in respect of the reliability of the information contained in this report.
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Edward Rizzo is a director at Rizzo, Farrugia & Co. (Stockbrokers) Ltd.