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From: Jim O'NeillSent: 04 January 2013 13:05To: gs-jims-viewsSubject: Is 2013 Going to be the Great Year of Rotation from Bonds to Equities?

  

Is 2013 Going To Be The Great Year Of Rotation From Bonds To Equities? A Happy New Year to one and all, and fingers crossed for an exciting and rewarding one. As has become the norm for me recently, I will await the first cumulative five days of the S&P 500 equity market trading to firm up my degree of confidence about things, which will be next Tuesday 8th January. Recall the great Almanac rule that, as others show, if the US market is net positive after the first five days of trading, with something like an 85% success rate since 1950, the market is not only up for the year, but it is around 14% gain on average. Ahead of this, five quite encouraging signs: First, the ongoing US fiscal cliff development has been laid to rest for now, well, at least for two months! Second, a number of key data points in the US and elsewhere have positively surprised during and since the holiday. Third, the domestically generated stories in both China and Japan kept their equity markets doing rather well over the holiday period, suggesting some positive carry-over for the rest of the world as well, of course, being good news for those of us investing in these countries. Fourth, there are further signs of the intensity of cross-market correlations breaking down since the post-2008 environment (witness the EUR/USD decline despite stronger stocks, for example) and fifth, there is some noise at least, and certainly investor enquiry, about a rotation from bonds into equities – at last, some might say! And to top it off, United are seven points clear coming into the New Year! All none too shabby, I’d say. The US Fiscal Cliff Topic. So, the whole topic turned out pretty similar to how I had thought. Now everyone is already wondering, worrying and debating what is going to happen with the same issues at the end of February, with some people referring to the next upcoming fiscal policy challenges as the “Three Canyons”. In terms of what was passed by Congress, what was averted, and what it means for fiscal policy, the more credible estimates suggest a 2013 tightening of something in the 1.5 to 1.6% of GDP vicinity which most people think is sort of about right, in terms of being credible, but not too draconian for the economy. More on this below. In terms of the next battle between the White House and the House Republicans, most voices seem to think that the battle in February will be much more difficult as the debt ceiling won’t get raised unless the Republicans get their desire for notable spending cuts. I am not going to take a strong view yet, but would note that it is interesting how broad a view it is already that it will be even more difficult to reach another deal then. People do like to worry, don’t they? Two other aspects of the topic intrigue me. First, given how this “game” has ebbed and flowed since the

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events of August 2011. As Tom Teles from our US Fixed Income team pointed out at our weekly CIO call on Thursday, the markets are learning to not pay as much attention to the topic as we creep through time. Second, and as Tom also pointed out, if the US data continues to improve – please note that this Viewpoint is being written ahead of the December payrolls, so beware – will it really be that critical? In this context, as I argued before the end of the year, the two main drivers of the improving US economy appear to be the housing story and the rising domestic energy-driven competitiveness. If the fiscal situation is not going to negatively effect either, then should we pay too much attention to it? Recent US And Other Key Global Data. Unless the December payrolls are surprisingly weak, recent data in the US portrays a further economic improvement, including the latest ISM Manufacturing Index, which rose to 50.7%, and the further widening between the new orders and inventory component is a welcome sign for the future. It is interesting to see that the relatively new “Markit” version – a US Purchasing Managers Index (PMI) – rose to 54.0% from 52.8% in November. Ahead of the job numbers, the ADP National Employment Report not only showed a higher than expected 215k rise in jobs, but the previous month was revised up to 148k. All of this followed the continuing good housing data and a welcome bounce in the last durable goods report, suggesting investment might not be as weak as seen earlier. Linked to my core theme of this Viewpoint, Thursday’s Federal Open Market Committee (FOMC) minutes raise the issue that not as many FOMC members seem to be so passionate about the extent of QE going into 2013. Furthermore, if the unemployment rate continues to decline, it would seem as though the US bond market is going to be quite sensitive to this. If this occurs, the big question is whether this is going to result in a shift in the equity-bond correlation or whether equities will just keep rising. More on this below. Related to the changing energy story, it was interesting to read about Mid-American Energy Holdings’ planned $2.5bn investment into solar power in California, suggesting that it is not just the shale oil and gas story which is changing so much, it is broader perhaps. Outside of the US, the data since the holiday period has been more mixed, but in terms of manufacturing, the JP Morgan Global PMI rose to 50.2% – the first rise above 50% since last May, with a number of large emerging economies putting in decent numbers, notably India (India’s services PMI rose sharply, too). From the rest of the developed world, the UK was the most striking improvement, jumping sharply to 51.4%. One would like to think this is for real in the UK, but the data pattern has been so erratic since the summer of 2012, it is hard to be confident. Euro area PMIs on aggregate were slightly disappointing with Germany and Spain softer than expected, but a further notable bounce in Italy which, oddly, at 46.7%, is the highest of the four biggest Euro area economies. Germany’s disappointing manufacturing PMI is not reflected in other data or the German mood. Porsche reported its full-year 2012 sales, showing a record year and a 21% rise over 2011. An interesting survey from Ernst & Young showed that German consumers appear quite confident, with some 88% of those surveyed thinking that their jobs are safe. This is to a large degree confirmed by the German service sector PMI rising to 52.0%, not quite as strong as the Flash PMI, but supportive of evidence that Germany is showing pretty strong signs of welcome rebalancing. Korea’s December export performance disappointed with a headline 5.5% year-on-year decline, but adjusted for the actual number of working days, in fact, it rose by 7.7%. China’s PMIs were not quite as punchy as hoped for, with the official PMI the same as November’s 50.7%, although the HSBC PMI showed a stronger rise to 51.5%, and the official services PMI showed a further robust bounce to 56.2%. With China taking holidays just as we came back, we haven’t seen a great deal of their 2013 trading. However, 2012 went out with a bang, with the post-leadership-change equity market rally continuing all the way until the last day of the year, turning the whole year into a small positive, and a 15% rise off the lows. Other Things That Caught My Eye.

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Quite a few other bits and pieces of note, including;

1. India’s balance of payments current account deficit deteriorated again in Q3 2012, rising to 5.4% of GDP, now into “must watch carefully” territory. Against that, or perhaps because of it, policymakers are trying to reduce gold imports further, a big part of the culprit.

2. Against this, some people from India have sent me materials about the beginnings of further exciting policy issues related to the Unique ID scheme that the government launched a couple of years ago. They are about to start something called the “Direct Cash Transfer” scheme which piggybacks on the Unique ID scheme and could be massively beneficial for reduction of waste and losses across the government’s fiscal programmes and help improve the banking system. It seems like a potentially very powerful development.

3. China announced earlier this week that it plans to invest some $11.2bn in Cambodia, which for this country is a huge amount of money and will involve a number of infrastructure projects planned for the next four years.

4. South Koreans seem suddenly to be full of angst, despite just recently having had an election and despite the fact that, on the GS Growth Environment Score (GES) published in late December, they rose to being the second highest in the world. These scores are a sign of strength and sustainable growth and productivity. But there appears to be growing signs of concern about the cost and intensity of education, and about some aspects of inequality. There is also some irritation amongst policymakers about the strength of the Won, perhaps not least at a time of Yen weakness, which some of Korea’s corporate titans won’t be too pleased about.

5. Auto ownership less popular? I recall mentioning this phenomena after reading an Economist story about it back in the autumn. The FT carried a small piece on the topic just before Christmas, in which they were quoting some auto executives in the US who said they had to adjust even faster to changing tastes and habits, especially amongst the urban youth, who don’t seem to be quite so obsessed with the auto as previous generations. This could be a huge topic and requires close analysis.

6. Mario Monti seems set to represent the middle ground in the Italian election, but so far, his grouping lags behind some others, including the left-wing candidate. Berlusconi’s bid is getting lots of media coverage, but – famous last words – I can’t see him returning.

7. The French constitutional court said that the proposed 75% top-earners income tax is unconstitutional. This has certainly added to the less-than-impressive picture in the first year for President Hollande, although it is likely he will try to come up with something not too dissimilar. Media stories report some well-known French figures are applying for, and being granted, Russian citizenship!

8. In Japan, the returning-to-power Abe appears to be getting various pieces in line to support his planned assault on the BoJ with a genuine 2% Inflation Target and a strong desire to weaken the Yen further through domestic monetary measures. He is resurrecting the Council on Economic and Fiscal Policy (CEFP) from Koizumi’s days, which will be led by monetary expansionists, notably Koichi Hamada as a special advisor. We await the 22nd BoJ meeting to see whether they will volunteer the shift to a 2% Inflation Target or get it imposed on them. Many technical indicators suggest that the Yen is a touch oversold, but that being said, as I have discussed for weeks, this is probably a major trend change. I could envisage a move back to the Y85 area, but I continue to think, in circumstances of a genuine 2% Inflation Target, the Yen is heading to the Y100-120 range in the next 12 to 24 months.

9. In the UK, there is suddenly some belief that one of the Bank of England’s schemes to boost bank lending is working with evidence of a notable rise in credit availability in the last three months under the so-called Funding for Lending programme.

Changing Correlations? There are a number of growing hints that the post-2008 environment of “risk on/risk off” with very strong cross-asset-class correlations is reversing. If this were true, it should be really good for specific investors

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who can concentrate on their asset class and not worry so much about extraneous forces. I had already touched on this a number of times during 2012, not least because smart investors should try to anticipate these trends reversing before the masses. But now, the evidence is accumulating. It is at its most apparent in the foreign exchange market, with the dramatic decline of the Yen since mid-November, which is clearly a function of the incoming LDP leader Abe planning for a more activist set of policies. Many sell-side commentators are still focused on the two-year US-Japan interest rate differential in following the Yen, which worked so well since 2008, but – at least for now – has clearly broken down. I would remind people that over a longer period – in fact, since the early days of floating – there is very little statistical evidence that US-Japanese interest rate differentials are that crucial for USD/JPY. Since the start of 2013 – and this is potentially dangerous to conclude as permanent – the Euro has declined, despite a strong rally in asset markets, including a continued powerful rally in peripheral European bonds. Then there is the ongoing softness of the Gold price that I talked about in my Viewpoint from 21st December, which the bulls will simply pass off as year-end positioning squaring and noise. However, if – as I shall discuss now – it is part of a re-emergence of equities and the end of the bond obsession, then this could be curtains for Gold. Rotation From Bonds Into Stocks? Which brings me to the topic of bonds and equities. With close colleagues in my office, we are re-examining closely the long-term performance of markets, especially bonds and equities, with a lot of emphasis on the context of the so-called Equity Risk Premia (ERP), which I often talk about. There is quite a lot of compelling evidence that, when the ERP is close to zero (as it was in 2000), you want to reduce your exposure to equities to as little as possible, and then – at the other extreme – when the ERP is close to 6.0, you want to do the opposite and get as much exposure to equities as possible and be rather way of bonds. (All of this is concentrating on so-called developed markets as the data history is richest.) This is notsufficient to really boost your investment performance and you need to take into account the level of real interest rates, too, and also probably some powerful cyclical economic indicators, such as the more useful lead and coincident economic indicators. In this regard, the ERP continues to be very high in the US and elsewhere, and of course real interest rates are very low. It is also the case since the late autumn, as discussed in previous Viewpoints, that some useful leading lead and lead indicators have turned more positive. All of these signals together suggest that it is increasingly dangerous to be heavily invested in government bonds, with the G7 central banks buying of their own markets perhaps the biggest supportive factor. Against this backdrop, it is most interesting to see the apparent degree of dissent on the FOMC about the degree to which they should pursue QE and, not surprisingly, the US bond market has suffered some weakness. It makes today’s payrolls especially interesting. And it raises the possibility that investors are starting to switch back from bonds into equities. As a large multi-product asset manager, we do not observe strong signs of this happening. However, given it is 4th January, it is unlikely many cautious long-term investors would be making such decisions so quickly. One would imagine plenty of interesting discussions coming up at pension fund trustee meetings and elsewhere. What is clear from the reported weekly ETF data is that recent inflows into passive ETF equity funds have been quite sizeable relative to bonds. Some argue that US equities will weaken if US bond yields rise for the obvious reason that higher yields compete – perhaps on the premise that there is less liquidity. Others throw in that, from a conservative valuation perspective, such as cyclically adjusted PE ratios (CAPE), equities are no longer attractive. On our GSAM CAPE calculations, it is the case that US equities are not cheap, but it is quite conceivable that they could become expensive again (just as bonds have for many years) if the great rotation trade is about to start. And moreover, many markets around the world remain quite cheap on a CAPE basis, whether it be Japan, much of Europe and, of course, the wonderful world of the Growth Markets and a number of emerging markets as well. So, let’s wait and see by the end of Tuesday 8th January trading whether the five-day accumulated performance remains positive, but clearly things have got off to a rather good start. We look forward to the

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dialogue with many investors on the topic of the great rotation or many other topics. Best wishes to you all as I said at the start, here’s hoping for a fabulous 2013. Jim O’Neill Chairman, Goldman Sachs Asset Management.   

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 Jim O’Neill is the Chairman of GSAM, which is a separate operating division and not part of the Global Investment Research (GIR) Department. The views expressed herein by Mr. O’Neill do not constitute research, investment advice or trade recommendations and may not represent the views and/or opinions of GSAM’s portfolio management teams and/or the GIR Department. Copyright © 2013 Goldman Sachs. All rights reserved. Please visit our website for additional disclosures.

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