Why ‘Great Rotation’ Narratives Should Always Be Rejected

Paul Kennedy, in his 1987 book “The Rise and Fall of the Great Powers,” forecast that Japan would continue to outperform the U.S. and Europe economically through greater exploitation of technology while freeriding on the U.S. defense budget.

In February 1988, the New York Times reported that international investors had jumped back into the Tokyo stock market. Strategists were no doubt arguing for a great rotation out of U.S. and European stocks into Japan, based on this narrative.

Fast forward to today. A more recent narrative from strategists is for a great rotation out of bonds into equities. This story notes that yields are unlikely to fall much further and any small increase in inflation expectations will drive up yields causing capital losses for investors.

With average dividend yields higher than government bond yields, there is even less reason to hold bonds. Furthermore, last month the IMF forecast global GDP growth to fall by 4.4% in 2020, with advanced economies expecting a 5.8% fall. As a consequence U.S. default rates are expected to rise to levels not seen since the financial crisis to around 12% from its current level of 6%.

Despite this potential shock to investors, U.S. bond spreads — even for the CCC rating category — have returned to pre-pandemic levels. The market, it appears, expects central banks to keep on buying corporate bonds, depressing spreads further, thereby generating higher returns.

Moreover, the inflation picture remains subdued with five year forward expectations below 2%, although the market is expecting inflation to head up towards 1.5% in November, based on the difference between the five-year TIPS spread and the nominal benchmark.

Exhibit 1: U.S. Bond Market Indicators

Our ability to understand the potential trajectory of complex systems is inherently limited, hence stories explaining the next big investment idea should always be treated with suspicion. While there is often a grain of truth in these narratives, other variables that tend to be ignored at the time often become more important, rendering such narratives redundant. In the case of Japan, it was unsustainable levels of private debt which resulted in equity values falling by more than 50% between 1990 and 1992.

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Thomas Aubrey is the founder of Credit Capital Advisory.

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