Capital flows: Is the great rotation finally here?

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Money has been flowing out of fixed income and into equities since Bernanke’s speech in May.

As the markets dust themselves down after their recent bout of Fed-induced nerves what might emerge is an overdue change in investor mindset. The fallout from late May and early June has not been pretty in some of the asset classes that have been clear targets of 2013’s chase for yield and might give some of the higher-risk-asset-class tourists pause for thought.

According to BlackRock, by June 20 the year-to-date return on emerging market local government debt was -7.2%, which would require 1.9 years of yield to recover and marks a peak-to-trough return of -10.5%. Emerging market corporates haven’t fared much better, with a year-to-date return of -4.5%. Compare this with Spanish government debt, which has still seen a year-to-date return of 4.5%. It is perhaps no surprise that by July 19 there had been eight consecutive weeks of aggregate outflows from emerging market debt funds, with $15 billion leaving – one-third of all inflows year to date.

BlackRock also calculated the yield rise required to trigger a price decline sufficient to wipe out one year’s worth of income for a number of bond asset classes. This safety cushion for emerging market local government debt and corporates, which suffered so badly in the volatility, is a comfortable 114 and 113 basis points respectively. Look at Japanese government debt, however, and it is a very scary 9bp. The figure for US treasuries is just 23bp.

While emerging markets certainly bore the brunt of Federal Reserve chairman Ben Bernanke’s comments, his words might have finally triggered a change in mindset among some investors. The numbers certainly seem to suggest so. According to Bank of America Merrill Lynch, there was $1.7 billion of outflows from US investment-grade debt funds and $1.1 billion from treasuries during the week of July 15, while $19.7 billion was invested in global equity funds – the largest figure since July 2008. Is this the great rotation that has been flagged up for so long, but has so far failed to materialize?

It might be. There has been a sharp rise in US real rates, and the Fed’s intentions with regard to asset purchases are clear. As central bank policies begin to diverge between the US, Europe and Japan, so will financial market returns between and within asset classes. This breakdown in correlation between bonds and equities looks more positive for equities: by mid-July equity markets had regained all their losses following May’s market disruption. This might be an important turning point for equity investors. But it is not all over for bonds. Rather than a great rotation, this might be the beginning of a very slow rotation. High-yield bonds, which are less sensitive to a backup in rates, still saw $4 billion in inflows during the week of July 15 – the biggest figure since October 2011. According to BlackRock, US high yield has a safety cushion of a very comfortable 149bp, so it will take a lot more tapering talk before its course is run. Despite being hard hit during the volatility, US high yield had still returned 1.7% year to date by the end of June.