A very popular theme among some investment advisers this summer is the potential for a great rotation from bonds into stocks. While this idea may have its day at some point in the future, our read of the current economic environment suggests caution for now in making a large scale allocation switch.
The great rotation theme requires an investor to commit to a significantly higher long-term allocation to equities and a smaller allocation to bonds than their current or historical target asset allocation. At its heart, as a long-term portfolio strategy, the great rotation theme depends critically on rising inflationary expectations. Bear markets in bonds that extend for multiple years or even a decade require the assumption of rising inflation expectations, year after year, such as was the case in the 1970s. We see no signs, however, that inflation expectations are not well-grounded at very low levels. While we do believe that inflation in the U.S. will creep higher over the next several years, we are not yet talking about the type of sustained inflation increases that would typically be associated with a bear market in bonds that last for several years or more.
What appears to have happened in the U.S. Treasury market is that the debate over the Federal Reserve’s potential exit from quantitative easing has triggered a regime shift to a new trading range for Treasury yields and a higher level of volatility. That is, the debate about when and how fast the Federal Reserve (Fed) will end its quantitative easing program of asset purchases has led to a sharp recalibration of U.S. Treasury yields, from 1.8 percent at the end of April 2013 to around 2.8 percent at the end of August. This horse has left the barn, and the actual tapering of quantitative easing, when it eventually comes, may be much less of a market event than the anticipation has been.
In addition to the rise in yields to a new trading range, there has been a contemporaneous rise in Treasury market volatility. The rise in Treasury market volatility takes us back to more normal and probably healthier levels that price the risk in the bond market more appropriately for the underlying economic conditions.
Our main conclusion is that the yield shift to a higher trading range due to the potential end of the Fed’s QE program should not be mistaken for the beginning of a long-term bear market in bonds. Certainly, it may happen eventually, but we would argue that without steady increases, year after year, in inflation expectations, the time for the great rotation has not yet arrived. For now, perhaps, short-run tactics trump long-run asset allocation strategy shifts, while we wait to see if any inflation pressures develop down the road.