October 29, 2014 / 5:48 AM / 3 years ago

The equity cult alive and kicking, despite deflation threat

5 Min Read

Traders laugh as they work on the floor of the New York Stock Exchange as the market closes in New York October 17, 2014.Lucas Jackson

LONDON (Reuters) - Anyone betting on another "Great Rotation" of investment flows out of bonds and into stocks is in for disappointment: it's not happening, and isn't going to.

In a world where deflation, never the most fertile ground for equities, is a bigger concern for policymakers than inflation, that seems a pretty safe call - but the surprise is that this time around both asset classes may be on to a winner.

Bonds tend to do better than stocks when inflation is weak because the value of the fixed income payments investors receive is protected. In periods of deflation the real rate of return is actually enhanced.

But many of the world's leading investment banks argue that the broader market backdrop - also characterized by low interest rates, low returns and high cash balances - leaves stocks just as well-positioned to benefit as bonds.

Even as the U.S. Federal Reserve withdraws its stimulus, there is a surplus of savings and central bank liquidity in the global financial system that needs to find an investment home.

"The equity cult and the bond cult can live side by side," according to Citi.

As a group, U.S. financial institutions are among the biggest investors on the planet, with more than $60 trillion of assets under management, according to UBS. And they are loading up on stocks.

U.S. mutual funds' net investment flows in stocks over a five-year rolling period troughed at round $550 billion net outflow in late 2012 compared with a peak net inflow of over $1 trillion at the end of the millennium, Citi analysis shows.

But that flow is now approaching neutral territory and is on track to turn positive next year.

To be sure, equities aren't cheap right now, particularly U.S. stocks. The S&P 500 has risen 170 percent from its post-crisis low in early 2009, and other developed markets have performed similarly well.

By some measures, valuations are getting stretched, especially with sluggish growth unable to prop them up. The third quarter earnings season now under way has shown many large firms on both sides of the Atlantic missing revenue and profit forecasts.

But many investors still consider them more attractive than bonds which currently offer the lowest yields in years, or in some cases ever.

The "equity risk" premium - how much more stocks are expected to return than bonds - is more than 7 percent in the euro zone and UK, and 10 percent in Japan. Even the lower U.S. premium of 6 percent, which suggests Wall Street is starting to look a little expensive, still offers a decent return.

Even those who think these risk premia are too low say there are reasons why it may be different this time, the main one being that the returns offered by bonds and cash are simply too low.

"Investors have no option but to accept higher risk if they wish to meet their future income requirements," said Keith Wade, strategist at fund management giant Schroders in London.

Wade also reckons that equity markets, much like bonds post-crisis, essentially now have the back of global policymakers, who will do all they can to support the economic recovery and prevent renewed financial market distress and volatility.

This was brought into focus two weeks ago when an explosion of volatility ripped through markets, sending bond yields tumbling and prompting the biggest fall in stock markets for years.

Officials from the Federal Reserve and Bank of England were quick to allay market fears with soothing messages of interest rates possibly staying lower for longer than previously anticipated. Wall Street and European stocks have rebounded between 5 and 7 percent from these panic-driven lows.

Citi predicts global stocks will rise a further 21 percent by the end of next year, while Barclays says European stocks are cheaper than at any point in the last 10 years because investors are pricing in a growth and deflation scenario that is "more pessimistic than warranted".

The 'shock absorber' for the deflationary forces currently being fought to varying degrees around the world will be a stronger dollar, argue Morgan Stanley and HSBC.

They say the U.S. economy is the only one of sufficient size and strength to withstand a rising exchange rate, the negative effects of which will be cushioned by lower energy prices.

Morgan Stanley, HSBC and almost every other major U.S. and European investment bank expect the dollar to strengthen next year. Many of them say the greenback is in the early stages of what is a multi-year rally.

If they are right the euro, sterling and Japanese yen all weaken, making their economies more competitive on the global stage and fuelling a recovery in growth and inflation, albeit from extremely subdued levels.

According to Goldman Sachs: "The backdrop remains one of sub-par growth, low inflation and low interest rates," an environment that's "unlikely to be very negative" for bonds and at the same time "positive" for stocks.

Reporting by Jamie McGeever and Francesco Canepa; editing by John Stonestreet

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