Asset Allocation for a New Era

Diversification, Not Rotation, is the New Watchword

Modern portfolio theory leads us to believe that asset management is easy: when yields start to fall in one asset class investors should just shift into a higher-yielding asset and by carefully shifting the proportion of these assets in a portfolio, risk will be minimized. It follows then that all of the money which transferred into bonds since the great financial crisis began will shift back to equities once interest rates start to rise again. Given where we are today in the economic cycle, the theoretical call to action should be “All aboard the equity express train!”

But what if it’s not that simple? What if there have been structural changes to the investing environment which derail the shift between bonds and equities? Or what if there was never really a relationship between the performance of the two asset classes and it was all just a coincidence? In this new Citi GPS report, Mark Schofield and Citi’s macro team conclude that investors expecting a “great rotation” out of bonds and into equities as the economic cycle turns are likely to be disappointed.

They’re not saying that there won’t be a significant flow out of cash into equities, as some investors reverse secular reductions in equity allocations going forward, but these are unlikely to be directly linked to bond selling. Instead of rotation, the major trend underway in asset allocation is diversification. Investors are not selling bonds to buy equities. Instead, they are diversifying out of traditional assets into a range of new assets and asset managers are creating platforms that make it easier for them to do this. There is a growing tendency for regional economic variances to drive capital allocation decisions, with asset class choice becoming a secondary consideration. On the supply side, a much broader set of available assets has evolved, with markets in real estate, commodities and foreign exchange emerging as asset classes in their own right. In addition, the huge growth in alternative asset platforms, including exchange traded funds and hedge funds, has also increased the demand for alternative assets. Finally, changes in the regulatory environment have historically had a meaningful impact on asset allocation flows and this impact will likely continue into the future.

If we’re not going to see a great rush back into equities, does this mean the equity cult is dead? Not necessarily. There is still likely to be continued inflows into equities due to relative valuation, the search for yield/ financial repression, improving risk-adjusted returns, upside optionality and reduced systemic risk, but not necessarily a “great rotation” into equities as bonds won’t see anticipated outflows until investors have a reason to sell them. That won’t happen until we see higher funding costs, higher volatility, or a real inflation threat. In the meantime, both the equity cult and the bond cult can live side by side.