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The big rotation trades in 2017

One of the more cherished bits of jargon used in finance is an idea that cash may sit on the sidelines, as if piles of notes are substitute players ready to dive into the great game of markets.

Investors are still sitting on large piles of cash, holding nearly 5 per cent of their portfolios in spare liquidity in December, according to data from BofA Merrill Lynch.

Keeping a close watch on which direction the money managed by large institutional investors is flowing provides valuable information for the contrarian seeking to get ahead of the market.

Below are four examples of these so-called rotation trades that may play out over the next year.

From bonds to stocks

Taken as a whole, 2016 was the worst year for flows out of equity funds since 2008, with $93bn pulled, according to Bank of America Merrill Lynch.

Yet one of the first tangible reactions to Donald Trump’s victory in the US presidential election in November was money pouring out of global bond funds.

Data provider EPFR recorded the second-largest weekly outflow since it began tracking the sector in 2002. In the same week, global equity funds attracted $27bn.

According to Nikolaos Panigirtzoglou, a strategist for JPMorgan who each week publishes a popular report dedicated to flows and liquidity, such shifts in sentiment stand out. “You see a change in several of the flow metrics at the same time, it’s less noise.”

“That was clearly the case after the US election, also the case after the August 2015 correction, the mood clearly changed,” says Mr Panigirtzoglou.

By the end of the year, there had been a $66bn rotation into US stocks, with investors anticipating tax cuts and policies from the incoming administration likely to spur higher inflation and growth.

Ahead of Mr Trump’s inauguration on January 20 it is hard to gauge confidence in what he may accomplish, but, “the typical flows that are associated with the Trump trade are still there”, says Mr Panigirtzoglou.

From the US to Europe

Concerns over lacklustre economic growth and political instability have resulted in global investors continuing to shun European equities going into 2017.

While sentiment appears to have shifted towards US stocks since November’s election, anxieties remain elevated over what the new year will bring for Europe.

The December edition of BofA Merrill Lynch’s monthly fund manager survey, which questions investors managing $473bn of assets, showed that a third of those believed that volatility in Europe would be the largest driver of global stock markets over the next six months.

Since the UK’s Brexit vote, sentiment has not improved, with the survey showing that a net 4 per cent of global fund managers intended to underweight Europe in 2017, the weakest 12-month outlook since June.

This pessimism has prompted some to argue that the same macroeconomic and political concerns hanging over the continent are presenting investors who have a longer-term focus, with attractive opportunities to buy high-quality companies at a discount to their US peers.

“My view is that many investors are being too top down and macro in their thinking about Europe and are missing a trick,” says Rory Powe, a long-only portfolio manager focusing on European growth stocks at Man GLG.

“Bottom up Europe is extremely interesting and is full of outstanding companies which are more global in the way they operate than companies from arguably any other region in the world. We can find gems in a region which is, from a stock picking perspective, uncrowded.”

Keep buying banks after their strong rebound?

Bank stocks have rallied since November as investors warmed to the idea that rising interest rates would boost the long-struggling sector’s profitability.

According to the BofA-Merrill Lynch investor survey, global fund managers shifted into an overweight position in bank shares from November to December in the largest move relative to the survey’s history since 2006. Although banks appear the trade of the month, other data shows that the sector remains lightly owned compared to recent history.

Allocations to global bank shares sit at a similar level to their highest levels of ownership seen in 2014 and 2015, but not significantly higher. This indicates that more fund managers may feel they are forced to start buying them if they feel the sector has truly turned the corner.

US asset manager Northern Trust late last year spoke of the rally in European banks potentially triggering a “pain trade” for fund managers who have long shunned the continent’s most troubled lenders.

From pummelling the pound to sterling stability

Selling the pound was the no-brainer currency trade in the second half of 2016. UK political turmoil, the government’s uncertain Brexit strategy and hawkish rhetoric from Europe politicians conspired to drive sterling to multiyear lows. The only question was how far and how quickly would it fall.

Revisions to that outlook for sterling tentatively began in the summer when the UK economy proved more resilient than expected, gained momentum when the government’s Brexit strategy was beset by legal problems and picked up further when investors started paying more attention to the likelihood of populist voter sentiment spreading in Europe.

Sterling is far from a safe buying trade since Brexit developments are frequent and complex, as the resignation this week of the UK’s ambassador to Brussels showed.

But analysts have begun to reflect on the pound’s cheapness, while data continues to turn positive.

The ambassador’s resignation, though regarded as a sign that the UK was shifting to a hard Brexit stance, had “almost no effect on sterling”, notes Commerzbank strategist Esther Reichelt.

At some point, the UK will offer some clarity on its negotiating position. Do not be surprised if a softer Brexit approach prompts a sterling recovery.

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