The word “great” is often used to describe a big shift in the markets: the Great Deflation (1870-1898), the Great Depression (1929-1942), the Great Recession (2007-2009). Now a new term has emerged: the “Great Rotation.”
Bank of America Merrill Lynch coined this term in a research note from October 2012, “The Bond Era Ends.” That report anticipated that beginning in Spring 2013 and for some time beyond, a large rotation would occur out of bonds into stocks, driven by record-low bond yields.
According to a recent Investment News article, the Great Rotation is beginning to look like the “Great Reversal” — as evidenced by the fact that, “investors shifted record amounts out of U.S. stock funds and into bonds in the seven-day period ended Feb. 5.” CNBC also reported on the recent shift from stocks to bonds, describing it as the “great rotation… in reverse.”
Many market observers view the recent shift from stocks to bonds to be the result of profit taking and rising market jitters led by a big sell-off in emerging market equities and debt. Could it also be that the “reverse rotation” is also a harbinger of what is beginning to happen in Europe — rising fears of deflation that could send all markets into an extended downward spiral, with stocks falling faster than bonds?
A Feb. 6 New York Times article, “Economists Sound the Alarm on Deflation in Europe,” reported that, “by whatever definition, some euro members are experiencing deflation now. Greece and Cyprus have been posting across-the-board price declines, and Portugal, Spain and Ireland are a whisker away from zero. Even in Germany, haunted by the historical hobgoblin of inflation fears, prices rose at an annual rate of just 1.2 percent last month.”
While the predication of the Great Rotation assumes that investors will flee bonds for stocks due to rock bottom interest rates, an extended period of deflation could create a different scenario. If the major developed economies all begin to struggle against the headwind of deflation, where to invest becomes even more of a challenge. Interest rates will generally be very low; however, stocks could also suffer greatly from the slow growth that often accompanies deflation. The Times article sums it up well: “When it takes hold, deflation — a decline in the general level of prices — undermines growth, and lowers corporate earnings and the values of assets.”
Most investors view bonds yields as unattractive from a current yield standpoint; however, if the U.S. should fall into deflation, rates could fall even further. Yield on the U.S. 10-year Treasury is approximately 200 basis points higher than the Japanese 10-year government bond and the U.S. long bond is about 200 basis points above Japan’s equivalent as well. Unbelievable as it may seem, U.S. interest rates can fall a great deal more, driven by many of the same forces that have been at work in the Japanese markets since the precipitous fall of the Japanese stock market in 1991.
Giving the steady decline of the Japanese stock markets and the subsequent steady fall of interest rates, Japanese government bonds represented a much better place to be in the 1990s than Japanese stocks. In fact, the Japanese 10-year government bond fell from a high of more than 8% in 1990 to under 1% by 1998. Since bond prices rise when interest rates drop, owning a significant amount of government debt would have provided a significant cushion against the Japanese stock market crash.
No doubt, being a well-diversified Japanese investor in 1990 just before the stock market crashed would be have been wise. Just as today, it is wise to remain diversified and not to invest in a way that makes one a leader in either the “Big Rotation” or the “Big Reversal.”
