The "Great Rotation" could finally be getting underway

The “great rotation” of investment capital out of bonds and into stocks might finally be getting underway.

For years analysts have warned about the looming end of the 30-year bond bull market. However, despite post-crisis central banking policy meant to incentivize risk-taking, U.S. treasuries continued to outperform U.S. equities – until last Wednesday. President-elect Donald Trump’s surprising victory sparked a rout in the bond market while injecting fresh life into stocks. And the risk-on trade showed no signs of abating this week.

Global bonds on Friday capped off their biggest two-week loss in 26 years, with the Barclays Global Aggregate Index falling more than 4% during the fortnight. The bond rout took a brief respite early in the week before the U.S. 10-year treasury added another 13 basis points in yield Thursday and Friday, closing at a 52-week high of 2.35%. The 10-year now yields more than the S&P 500 for the first time this year.

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To quantify the shift into stocks, U.S.-based equity exchange traded funds (ETFs) took in $27 billion during the week ended Thursday, the largest weekly inflows on record since Lipper started keeping track of the data in 1996. Meanwhile during the same period, investors withdrew more than $9 billion from U.S. based bond funds. The damage wasn’t confined to the treasury market, either. U.S. municipal high yield bonds experienced $1.6 billion in weekly outflows, the most since Lipper began keeping such statistics in 1992.

Sector-wise, financials continue to be the big winner. A steeper yield curve, which improves net interest margins, and hopes for less stringent regulation under the new administration led the Financial Sector SPDR ETF (XLF) to accumulate a record $4.9 billion of inflows in the week following the election, more than it had amassed total in the past three years.

Internationally, emerging market (EM) bonds have been the biggest losers. EM debt funds had their biggest weekly outflows ever, ranking first among global asset classes for outflows as a percentage of total invested capital. Emerging market borrowers owe $3.2 trillion of dollar-denominated debt, making payment more difficult when the dollar rallies as it has since the election.

Europe wasn’t spared in the carnage. Long-dated European bonds have gotten hammered, with the principal on Italy’s 50-year bonds sold in October already losing 13%. Austria sold $2.2 billion worth 70-year bonds only four weeks ago, but based on rampant demand could have sold six times that amount. Two weeks after delivery, those investors are already faced with a 10% paper capital loss. The market value of the world’s negative-yielding debt pile also fell 14% ($1.4 trillion) in the two weeks following the election.

Ray Dalio, founder of the world’s largest hedge fund Bridgewater Associates, in a LinkedIn blog post Tuesday wrote: "There is a good chance that we are at one of those major reversals that last a decade" and "there's a significant likelihood that we have made the 30-year top in bond prices."

Sean Darby, the chief global equity strategist at Jefferies, wrote in a note to clients on Friday: "Last week’s fund flow data may go down in history as the first real indication of the switch from bonds to equities."

President-elect Trump’s ambitious plan to dramatically cut taxes while spending up to $1 trillion on infrastructure projects is being credited with raising inflation expectations, but there could be another force at work. Bond vigilantes, investors who enforce fiscal responsibility though fixed income allocations, are saddling up again after years on the sidelines. Given the businessman-cum-politician’s history with bankruptcy, America's creditors could be hoping to preemptively rein in excessive public spending. President Bill Clinton, for example, had to forego a planned middle-class tax cut in his first term when bond vigilantes drove up U.S. treasury yields. Goldman Sachs is worried such aggressive fiscal policy maneuvers during a mature stage of the economic cycle risks creating stagflation – or inflation in the absence of growth, which erodes living standards.

Bonds haven't been the only asset class setting records. The dollar indexclimbed to its highest level in almost 14 years Friday, rallying more than 14% in the last two weeks (the largest such advance since March 2015). The greenback’s 7% two-week rally against the Japanese yen was the second-steepest in the history of floating exchange rates and the largest gain since January 1988. The Euro, meanwhile, fell to an 11-month low.

Major questions remain about the President-elect’s ability to simultaneously slash taxes and do massive stimulus (especially given the Republican-led Congress's penchant for fiscal restraint), but for now markets reflect the possible beginning of a major paradigm shift in asset allocations.

MARKET SEES DECEMBER RATE HIKE AS DONE DEAL

Implied odds of a December rate hike briefly dipped below 50% on election night before recovering back above 80% days later. Now, the move has become all but a foregone conclusion.

Traders took a breather early this week to wait for more information from the Federal Reserve, but they got the winks and nods they needed to increase bets on a monetary tightening. In testimony Thursday before Congress’s Joint Economic Committee, Fed Chairwoman Janet Yellen said the Fed could raise rates “relatively soon” (code for “in a couple weeks”) after a strong few months of economic data. Most notably, consumer prices in October rose at their fastest pace in two years into the Fed’s inflation target range. Retail sales, the biggest driver of U.S. economic growth, also climbed more than anticipated(0.8% actual vs. 0.6% expected) in October while year-over-year sales increased 4.3%, a two-year high. Implied odds of a December hike are now greater than 95%, although the chairwoman offered few clues about the pace of 2017 policy moves. 

Several prominent firms, including PIMCO last week, speculated the Fed might need to accelerate the pace of its monetary tightening in light of the rapid rise in inflation expectations, but Yellen maintained the near-term risk of “falling behind the curve” is limited. “When there is greater clarity about the economic policies that might be put into effect, the committee will have to factor those assessments of their impacts on employment and inflation and, perhaps, adjust our outlook,” she said.

Yellen also sent an indirect message to President-elect Trump, cautioning Congressional leaders about running high budget deficits with the labor market near full employment, inflation starting to heat up and debt-to-GDP nearing dangerously-high levels. She expressed hope Congress would focus on stoking productivity gains while maintaining flexibility to ramp up fiscal stimulus if the economy runs into trouble.

Amid suggestions the Trump administration might gut Dodd-Frank, Yellen also defended the post-crisis legislation, saying “appropriate reforms” have made the system “safer and sounder.” After attacks on her performance from the President-elect during the campaign, Yellen also emphasized the importance of Fed independence and reiterated intentions to stay in the job at least until her term expires in January 2018. The Fed could still come under greater scrutiny from the incoming administration, with several members of President-elect Trump’s economic advisory team having called for the Fed to begin unwinding its $4.5 trillion balance sheet.

House Financial Services Committee Chairman Jeb Hensarling, reportedly a candidate for Treasury Secretary, said this summer: “It is way past time for the Fed to commit to a credible, verifiable monetary policy rule, to systematically shrink its balance sheet and get out of the business of picking winners and losers in the credit markets.”

David Malpass, a senior economic advisor on the Presidential Transition Team, says the Fed’s bond purchases “have been very harmful,” adding it “needs to communicate a plan for downsizing its balance sheet.”

The President-elect’s cold embrace of the current monetary policy regime is just another factor driving up bond yields.

JAPAN SENDS STRONG MESSAGE TO BOND INVESTORS, AMERICAN PRESIDENT-ELECT

Japan stands to lose as much as any country if President-elect Trump follows through with campaign rhetoric, prompting government officials to send a pair of strong messages to markets this week. First, Prime Minister Abe rushed to be the first foreign official to meet with the incoming American president. Second, the Bank of Japan (BoJ) reminded investors of its commitment to keep interest rates low at any cost.

For now, things in Japan are looking OK. GDP surprised to the upside this week, expanding 2.2% versus expectations of 0.8%, in the strongest expansion since early 2015. Given the major trading partnership between the two countries, a stronger dollar/weaker yen dynamic has allowed Japanese exports to stage a major comeback and the Nikkei 225 index to trade at 10-month highs.

However, trouble could be on the horizon amid increasing protectionist trade sentiments and rising global bond yields. During their meeting, Prime Minister Abe and President-elect Trump focused on the Trans-Pacific Partnership (TPP) and the countries’ long-standing military alliance.

Last month the Bank of Japan (BoJ) announced a shift in its monetary policy approach. Rather than setting fixed monthly asset purchases, the central bank would buy as many bonds as necessary to keep 10-year yields around 0%. The BoJ conducted its first operation under the new framework on Thursday. Although no sellers stepped forward to match the central bank’s unlimited bid for two- and five-year notes at yields of minus 0.09% and minus 0.04%, respectively, the move served as a demonstration of the BoJ’s commitment to stated policy. The market responded to the show of strength, with five-year Japanese government bond yields immediately falling three basis points to negative 0.095%.

"Because the BOJ now fired a shot, people have probably realised that they don't need to do panic-selling," said Koichi Sugisaki, the vice president of research at Morgan Stanley MUFG Securities.

The ongoing relationship between Japan and the United States will be one to watch.

U.K. ECONOMY STARTING TO FEEL NEGATIVE SIDE EFFECTS OF BREXIT

The U.K. economy is also starting to suffer under the strain of Brexit. While the unemployment rate fell to an 11-year low of 4.8%, the labor market added only 49,000 jobs in October – half of the expected gain and well short of the three-month average increase of 172,000. Inflation is also taking its toll on living standards, with real wages growing only 1.7% in the third quarter – the slowest growth since Q1 2015.

The European Central Bank (ECB) is talking to banks about moving some operations from London to the continent, and Bank of England (BOE) Governor Mark Carney warned they could expedite the process if a “hard Brexit” continues to look likely when next summer rolls around. Banks have started to soften their tone after Prime Minister Theresa May extended an olive branch, but skepticism remains about her ability to secure both control over immigration and ongoing access to the European single market.

Patience is also wearing thin in the EU for the U.K.’s chaotic political process. “You can’t say... we want access to the single market but no free circulation of people. It’s obvious that doesn’t make any sense whatsoever,” said Italian Economic Development Minister Carlo Calenda. British Foreign Secretary Boris Johnson is already at odds with European Parliament’s representative on Brexit matters, Guy Verhofstadt, after saying the free movement of labor in Europe is a “myth.” Verhofstadt replied on Twitter he “can’t wait to negotiate” with Johnson so he can read him Article 3 of the Treaty of Rome, which outlines common duties and commercial policies in the EU.  

QUOTE OF THE WEEK

“At this stage, I do think that the economy is making very good progress toward our goals, and that the judgment the [Federal Open Market] committee reached in November still pertains.” 

- Federal Reserve Chairwoman Janet Yellen in her testimony Thursday before Congress’s Joint Economic Committee, which boosted implied odds of a December rate hike to 95%

FURTHER READING

After getting burned by airline stocks in the 1990s, Warren Buffet joked he was an “aeroholic” who needed a toll-free support hotline to talk him out of any new such investments. However, recent 13F filings show the Oracle of Omaha has fallen back off the wagon: Berkshire Hathaway disclosed stakes in American Airlines, United, Delta and Southwest Airlines. What caused Buffet to succumb to temptation? Harvard Business Review highlighted two likely factors: 1) Mergers have consolidated pricing power in the industry 2) A small set of large institutional investors – Blackrock, Vanguard, State Street, Fidelity, PRIMECAP – have acquired significant stakes in competing airlines. Buffett once blamed “kamikaze pricing tactics of certain carriers” for the failure of his airline investments. He must now feel confident "competitors" will play nice for the good of the industry, to the detriment of consumers.

The faltering yuan, which this week hit an eight-year low against the dollar, has more to do with economics than President-elect Trump – but Chinese policy makers are reportedly ready to intervene to stem the capital flight. 

The U.S. geological survey said Tuesday it found the largest oil deposit ever in the Midland Basin portion of Texas's Permian Basin. The Wolfcamp Shale could yield 20 billion barrels of oil worth up to $900 billion.

Minutes from the European Central Bank's (ECB) October meeting showed the board will decide at its December meeting whether to extend asset purchases beyond March.

Oil prices surged again this week amid a renewed push from OPEC membersto finalize an oil production cut before meeting in Vienna later this month.

Despite President Rodrigo Duterte’s colorful rants, the Philippines posted the strongest economic growth in Asia at 7.1% thanks to government spending spree.

Italy’s business leaders are saying ‘Si’ to Prime Minister Matteo Renzi’s constitutional referendum, but polls show him likely to lose the vote.

Snapchat files for $25 billion IPO, but this is the worst year for IPOs of U.S. companies since the Great Recession.

The Tesla-Solar City $2 billion merger deal was approved overwhelmingly by shareholders.

Germany’s GDP growth fell short of expectations while Italy’s exceeded forecasts.

Samsung to buy Harman International in an $8 billion bet on connected cars.

The stronger dollar makes global financial intermediation more expensive.

Base metals retreated this week after their initial post-election spike.

Theranos whistleblower shook the company—and his family.

SEC Chair White to step down from her post in January.