A prevalent thought seems to be that we are in the midst of a “great rotation” from bonds into stocks, which will continue to propel stock prices higher. This is a great theory and makes for nice headlines, but looks more like wishful thinking by Wall Street. The reality is that demographics are destiny and the shift instead into fixed income from equities is in the beginning innings. The following chart and quote from Morgan Stanley sum it up nicely.1
Published by Morgan Stanley Research on October 8, 2013 Ageing demographics mean regular income, capital preservation and lower volatility are key We expect that ageing demographics will subdue the strength of this rotation relative to history and will drive convergence between the Retail market and the retirement market. The reduction in equity allocations for the >60 age bracket over the past decade (based on ICI data for the US market) plus the ageing demographic (consultants estimate that within five years nearly 75% of Retail assets will be owned by retirees or those close to retirement) clearly call into question the sustainability and strength of this rotation back into equities. By the end of the decade, the weight of Retail money will be in decumulation phase, as it is in Japan today. We expect that regular income, capital preservation and lower volatility outcomes will be the key focus of this investor group. Published by Morgan Stanley Research on October 8, 20132Bottom line is that the “decumulation” phase is just beginning in most developing countries. The statement that within 5 years, nearly 75% of retail assets will be owned by those retired or near retirement is almost shocking. Just how much of the world’s assets are held by retail? Morgan Stanley recently released a report estimating that approximately $89 trillion of investible assets exist globally and of that about 60% is institutional and 40% retail.3 This translates to approximately $36 trillion in retail assets globally. Those at retirement age in all countries don’t care about Ibbotson charts or expected returns. They want tangible income and principal protection.
The demand is also there on the institutional side, with institutional investors now beginning their aggressive move toward LDI (liability driven investing). LDI is being used not only by insurers, but now by the global defined benefit (“DB”) plan market. Keep in mind that defined benefit and defined contribution pension plans encompass a significant portion of that 60% of global investible assets that is attributed to institutions. As equities have soared over the past five years, many of these large DB plans have seen their funding ratios come close to 100%. Originally, our thinking was that these plan sponsors would continue to “game” pension accounting keeping equity allocations high. What we mean is that pension accounting is pure voodoo; “expected returns” of asset classes based on historical numbers enter into the way DB plans have to fund their liabilities. Plan sponsors seem to be choosing LDI as a way to “immunize” this liability rather than roll the dice with equities.
LDI is similar to banks running a fully hedged book. When interest rates rise, the present value of pension plan liabilities fall. But of course when rates rise, most bond prices fall offsetting the liability gains. Conversely, when interest rates fall the present value of liabilities rise offset by a gain in bond prices. Ultimately it is expected that the desire for those running U.S. pension plans to match liabilities will encourage “de-risking,” moving away from equities into the fixed income realm. We have already seen evidence of this de-risking globally.4
For instance, in the United Kingdom, equity allocations have fallen from 68% to 39% over the last decade, and could ultimately fall as low as 10% for defined benefit plans.5
The point we are trying to make is that demand for bonds and other fixed income asset classes is coming from both the retail and institutional investor and that demand is expected to accelerate as the trend of de-risking away from equities and into fixed income is firmly in place. We expect the demand for Treasuries and other fixed income securities to remain strong, and even accelerate as demographics become more of a factor. We would expect that this, along with the economic headwinds, will constrain rates going forward.
1 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 13.
2 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 20.
3 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 15.
4 Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 17.
5Hamilton, Bruce, Matthew Kelley, Anil Sharma, Andrew Sheets, Anton Heese, and Matthey Hornbach. “Great Rotation? Probably Not,” Morgan Stanley Blue Paper, Global Asset Managers, October 8, 2013, p. 18.