DEUTSCHE BANK: The rotation from bonds to stocks is just getting started

Donald Trump has had an immediate and positive impact on financial markets since winning the US election a fortnight ago.

It’s an outcome that few expected based on recent commentary to the contrary.

Stocks and the US dollar have soared.

The three major US stocks indices — the Dow Jones Industrial Average, S&P 500 and Nasdaq — all closed at record highs on Monday, a scenario not been seen since late 1999.

Despite a modest stumble to start the week, the US dollar has also been screeching higher with the US dollar index, or DXY, hitting the highest level since 2003 last Friday.

Bonds, at the other end of the spectrum, have been walloped, sold off to a degree few imagined possible before the election result was known.

It’s been a topsy-turvy ride for investors, and the exact opposite market reaction to what was seen in the immediate aftermath of Trump’s win.

These charts from Deutsche Bank’s strategy team underline that point. It shows weekly US stock flows, along with those from global bond markets.

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At $US31 billion, flows into US stocks in the week following the US election were the highest level on record.

Explaining where much of those floes came from, outflows from bonds totaled a whopping $US18 billion, a level not seen since the so-called “taper tantrum” in mid-2013, when then US Federal Reserve Chair Ben Bernanke first mooted a scaling back of quantitative easing.

There was also a sharp $US5.4 billion movement out of emerging market stocks, reflective of flows being repatriated into US dollar assets.

After such as sharp and sudden move, the question everyone is now asking is what happens next?

Will the recent market moves be the start of a multi-year trend, or simply a short-term aberration?

To Parag Thatte, Rajat Dua and Binky Chadha, strategists at Deutsche Bank, the move since the US election is likely a sign of things to come, suggesting that while the flows seen last week were extremely large, they “still represent only a modest turn after many years of rotation out of equities and into bonds”.

This chart from Deutsche certainly makes that point, looking at cumulative capital flows into stocks, bonds and money market funds since the beginning of 2015.

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Even with the recent rotation out of bonds into stocks, it suggests many investors remain underweight stocks and overweight bonds.

“The flow overweight in bonds is running at a massive $US800 billion with equity inflows commensurately running well below trend,” the trio say, pointing to the chart below.

“As rates rise, we should see a continued rotation out of bonds and into equities.”

AP Images

They point to the bond taper tantrum of 2013 as an indication of the potential pace of reallocation.

“In the second half of 2013 as bond yields rose sharply equities saw inflows at a $US400 billion annual pace, the best period of inflows in this recovery,” they say.

Based on modeling conducted by the bank, Chatte, Dua and Chadha suggest that stocks tend to gain 5% for every $100 billion of inflows.

This, they say, suggests recent market moves have significantly further to run.

“(Given) massive cumulative over allocations to bonds and under allocations to equity imply the amounts so far represent barely a beginning.”

The trio say that the consumer discretionary sector is now the cheapest sector on the S&P 500 “once sector valuations are adjusted for growth and payouts”.

They also believe that within stocks, the rotation out of defensive into cyclical sectors will also continue.

“A big overhang from inflows into defensive funds remains and the cyclical/defensive rotation therefore has further to run,” they say.

“Stay long Financials/short Staples.”

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