Corporate Solutions

The week after the resolution of the fiscal cliff, in which Washington avoided over $500 billion in automatic spending cuts and tax increases, investors poured an astounding $9.2 billion into US equity markets, which rallied significantly in the process.

This led much of the media and many sell side analysts, to declare the ‘historic equity inflows’ signaled the beginning of a ‘great rotation’. As Reuters journalist Mike Dolan puts it, “The gist of the [‘great rotation’] argument is that investor holdings of now expensive, ultra-low yielding government debt – following a virtually unbroken 20-year bull market in bonds – are ripe for rebalancing.

The attraction of relative and absolute valuations in equity will coax the outflow to stocks.” Such a paradigm shift in investor preferences would have broad implications for companies seeking to attract investors to their stock. Under a ‘great rotation’ type scenario where investors are flocking bond markets to rebalance towards equities, that objective would be made easier, and one would expect such inflows to continue and be supportive of a broader market rally.

However, if the ‘great rotation’ is nothing but a myth, then the nature of the recent equity inflows may be more of a transitory phenomena than a broad based shift in investor preferences.

Recent data has cast into doubt the existence of a ‘great rotation’. Bond flows haven’t skipped a beat…

Source: Thomson Reuters Lipper Funds Data. Flows include both mutual funds and ETFs.

Note: Data is obtained on a weekly basis; dates indicate the Friday of that week.

…and money market flows YTD have been mixed at best. And while equity inflows have been substantial, most of that money has gone abroad.

Source: Thomson Reuters Lipper Funds Data. Flows include both mutual funds and ETFs.

Note: Data is obtained on a weekly basis; dates indicate the Friday of that week.

In fact, domestic equities have not seen a steady inflow; while the first and last weeks of January saw very large inflows, investors drew some of their money out of the market in the second and third weeks.

So evidence for the great rotation simply isn’t there—that’s not to say this event won’t happen at some point when the macro environment improves and interest rates begin to rise, just that it hasn’t happened yet. Still, cumulative domestic equity inflows YTD have been impressive enough to warrant an explanation.

If it’s not a rotation away from bonds that’s bringing money into the equity markets, where is the money coming from? We believe this is an important question to ask, as it can give us insight into (i) how long these equity inflows will continue and (ii) the sustainability of this ongoing rally.

Many analysts, including Andrew Hollenhorst at Citi and Jeffrey Hopson at Stifel Nicolaus, believe the significant amount of accelerated dividend and bonus payments—paid out in the run-up to the fiscal cliff to avoid expected tax increases—are the best explanation for the recent jump in equity inflows.

First, data from the Federal Reserve shows an unusual climb in deposit inflows during December, supportive of a one off income increase. This was corroborated by data released by the Bureau of Economic Analysis last week, which showed an abnormally high increase in December personal income.

Accelerated bonus and dividend payments would explain the jump in (i) bank deposits and personal income in December and (ii) large deposit outflows and money market fund/equity/bond inflows in the first week of January. Thus, investors appear to be re-investing these one-off income payments rather than rotating out of bonds into equities. Given this is a one-time source of income, the duration of these equity inflows is likely more transitory in nature than one would assume under the ‘great rotation’ scenario.

In summary, the shift towards equities may well occur as part of a long-term trend when the macro environment improves and interest rates begin to rise. That being said, that time has not yet come. Recent equity inflows are not only disproportionately international, but also more likely a transitory phenomena. As such, IR teams should refrain from operating under the assumption that investor preferences are undergoing a broad based shift towards equities.

For more information, please contact Ted McHugh at edward.mchugh@thomsonreuters.com