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Say hello, wave goodbye: rationale for the great equity rotation

The great rotation is one of the highest conviction themes at Bank of America Merrill Lynch with the investment bank believing 2013 will give way to a new leadership in equities and value stocks.  

Japan: back to the 1930s

Japan is the last of the Great Reflation Trades. Japan’s recent humiliating landmarks (eleven Finance Ministers in 7 years, government debt topping 1,000,000,000,000,000 yen, i.e. one “quadrillion”, sales of adult diapers exceeding those of baby diapers) argues for an unprecedented policy response. It worked in the early 1930s (chart) and the reflationary zeal of today’s policy makers in Japan means that we are now secular buyers of the region on dips.

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Japan: back to the 1930s

Japan is the last of the Great Reflation Trades. Japan’s recent humiliating landmarks (eleven Finance Ministers in 7 years, government debt topping 1,000,000,000,000,000 yen, i.e. one “quadrillion”, sales of adult diapers exceeding those of baby diapers) argues for an unprecedented policy response. It worked in the early 1930s (chart) and the reflationary zeal of today’s policy makers in Japan means that we are now secular buyers of the region on dips.

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The Great Rotation

The Great Rotation is one of our highest conviction themes. 2012 will likely go down as the higher watermark for trades geared to the 'Era of Deleveraging' in our view, as the outperformance of creditors over debtors peaked in July 2012.

We believe that 2013 will be a year of transition and the recent leadership of fixed income and scarce growth, and old leadership of commodities, will give way to the new leadership of equities and value stocks. In addition, the highly correlated macro market will give way to stock-picking and market dispersion.

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Policy: hello exit strategies, goodbye QE

Central bank liquidity has been by far and away the most important driver of asset prices since the Great Financial Crisis. Liquidity has been the basis for our 'I’m so bearish, I’m bullish' view of financial markets over this period. But the straws in the wind suggest the period of maximum liquidity is close to an end. Yes, the Japanese reflation is gaining steam in 2013 but we regard this as the last of the great reflations.

Meanwhile, the Fed has changed its 'exit strategy', BoE QE has stalled, and the main source of European liquidity injections, the Swiss National Bank, no longer needs to add liquidity via FX reserve accumulation as the Swiss franc begins to depreciate versus the euro. The high liquidity-low growth regime was maximum bullish for bonds. Ultimately, the shift to a lower liquidity-higher growth regime should prove very bullish for stocks.

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Pricing: hello inflation, goodbye deflation

As deflation ends and inflation expectations become anchored in a normal range, so risk appetites and interest rates should also normalise. Bonds tend to be very negatively impacted by inflation, particularly when it rises above 4%.

Meanwhile, in the past 50 years, inflation in the 1-4% range has been the sweet spot for equity returns versus bonds. So long as global inflation remains between 1-4%, investors can look forward to a period of multiple re-rating for equities, provided that EPS grows rather than declines.

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The two great risks: 1994 & 1987

The best case for markets in coming quarters is a repeat of the early-1960s, when both equities and bond yields rose in an orderly fashion. However, the coming transition is very unlikely to be as smooth. The two major risk scenarios to an orderly Great Rotation are: a bond crash as in 1994; a risk shock as in 1987, driven by a currency war. Gold is the natural hedge in 2013 against such risks.

1994

The current level of US jobless claims (335K) is the lowest since Jan 2008, when the unemployment rate was just 5.0%. If the global economy and corporate animal spirits revive sufficiently to cause an upward surprise to US payroll numbers in coming months, say numbers in excess of 300K, then a repeat of the 1994 'bond shock' is likely. In recent months we’ve drawn a number of comparisons to market returns in 2012 and 1993, the last year banks assumed major global leadership.

In 1994 the combination of stronger-than-expected payroll, a tighter Fed, a 200bps back-up in yields led to a big pause in the nascent equity bull market and a savage reversal of fortune in leveraged areas of the fixed income markets (e.g. Orange County & Mexico). Investors banking on economic recovery should therefore be reducing longs positions in high yield and EM debt.

1987

In contrast, in 1987, rising risk appetites caused equity prices to drag bond yields higher. At the same time, policy tensions over currency valuations between Germany and the US also put upward pressure on bond yields, as well as gold prices.

Ultimately the combination of policy risks, rising gold and bond yields helped precipitate the October crash in equity markets. A repeat of 1987 is a low probability event in 2013. But it is also clear that risk appetite is on the rise, many countries are trying to devalue their way to growth, risking a currency war, and should gold start to respond favourably to this backdrop, we would certainly worry that a major risk correction is imminent.

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Japan: the last great reflation trade

We remain overweight Japanese equities and would use pullbacks to add to positions. We are always big buyers of 'humiliation' and in the past 12-18 months Japan has sadly racked up the following list of embarrassing landmarks: its 3rd recession in five years, its 11th Minister of Finance in seven years, a violent shift from trade surplus to deficit, government debt topping the one quadrillion yen mark (that’s 1,000,000,000,000,000 yen) and the lowest valuation for Japanese bank stocks in over 30 years. To top it off, the demographics have deteriorated to such an extent that Japan has become the first country where sales of adult diapers now exceed those of baby diapers.

But policy makers are at last responding. The BoJ has adopted a 2% inflation target, will provide an open-ended asset purchase program, and ¥10.3trn of fiscal stimulus. While it will take time for these easing measures to meaningfully stimulate the economy, it’s important to note the impact they have on the medium-term outlook for bonds. Our Japan bond strategists Shogo Fujita and Shuichi Ohsaki have now revised up their yield outlook beyond the next two years, as they believe the longer-term policy environment is no longer bond market friendly.

Note that Japan has responded before in a massive fashion. Ben Bernanke’s reference in 2003 to finance minister Korekiyo Takahashi’s brilliant use of reflationary policies to rescue Japan from the Great Depression in the early 1930s was well deserved.

In December 1931 Japan departed from the gold standard, causing massive yen depreciation. Soon after, Takahashi proposed that the BoJ underwrite government bonds, and slashed the discount rate from 6.6% to 3.3% over a period of four years. Equities corrected initially, but then rebounded 153% between late 1932 and early 1934.

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