Follow the money, not the economy

With a credential earned, real education begins

There is a rite of passage for newly minted CFA charterholders. It arrives when the realization sets in that years of rigorous study have only scratched the surface of what drives markets.

Financial theory is elegant. The Capital Asset Pricing Model and Modern Portfolio Theory are clean, logical frameworks. But as practitioners quickly learn, elegance rarely survives contact with real-world markets.

The year 2026 offers a case in point. Finance textbooks posit that equities, bearing greater risk than bonds, should compensate investors accordingly. This equity risk premium serves as the foundational logic behind every multi-asset portfolio. Yet earlier this year, the trailing earnings yield on U.S. equities dipped below the yield-to-maturity on U.S. Treasuries. The riskier asset was – by this measure – compensating investors less.

It is exceptions like this that earn economists the charge of “physics envy.” There is a yearning to reduce complex and dynamic systems to repeatable laws, only to be humbled by the markets’ refusal to comply. Sir Isaac Newton understood the feeling. After surrendering to the mania of the 1720 South Sea Company bubble and watching a fortune evaporate, he remarked, “I can calculate the motion of heavenly bodies, but not the madness of people.”

Against this backdrop, this article explores capital rotation and how flows shift across asset classes throughout economic regimes. Through conversations with Juan Correa, chief strategist of global asset allocation at BCA Research, and Kevin Headland, CIM, co-chief investment strategist at Manulife Investment Management, The Analyst examines not only what happens, but what drives these shifts – and what investors can take away for the cycles ahead.

Capital rotation in theory

The theory of how capital flows across market regimes is well-documented. Stagflation, characterized by rising inflation alongside slowing growth, is challenging for both equities and bonds. A Goldilocks environment of rising growth and contained inflation benefits both. An overheating economy favors equities over bonds. And in a slowdown, bonds generally outperform.

Over the long run, both asset classes are anchored by fundamentals. For bonds, the starting yield-to-maturity is the clearest guide to long-term returns. As Correa notes, period-to-period deviations come down to interest rate expectations. A growth slowdown matters not because growth is slowing, but because the market anticipates rate cuts. An overheating economy sends the opposite signal. A stagflationary environment constrains the central bank’s ability to ease even as growth deteriorates, punishing bonds from both sides.

For equities, Correa frames long-term returns as a function of earnings growth and changes in the price multiple. With earnings generally growing through most periods, equity returns across regimes are primarily driven by changes in price multiples. In stagflation, the risk-free rate stays elevated while the risk premium rises, compressing multiples from both sides. In a slowdown, the equity risk premium initially widens as fear takes hold, then reverses as investors price in central bank intervention. The crash of 2008 and the junk rally of 2009 illustrated both ends of this dynamic.

The gap between investment theory and practice explains why tactical asset allocation has a reputation problem.

Regime change

The gap between investment theory and practice explains why tactical asset allocation has a reputation problem. Its track record has been underwhelming and easy to dismiss as market timing dressed in academic language.

Correa’s own research provides empirical grounding for that skepticism. A BCA study of 79 U.S. public pension funds managing US$3.2 trillion in assets from 2008 to 2022 found that the value derived from tactical asset allocation was, at best, marginal. It was strategic asset allocation, the long-term policy mix, that explained nearly all the performance differential between top and bottom performers.

“Prior to COVID, you could look at asset allocation like a 100-piece puzzle,” Headland explains. “You had certain economic factors and signals; it was almost foolproof. Now it is a 1,000-piece puzzle.” The two-factor, four-quadrant model of growth and inflation no longer captures the full picture. Geopolitical risk, the proliferation of retail investors and the ease of access to exchange-traded funds have made sentiment and momentum dominant forces in asset prices.

And yet both Correa and Headland make a compelling case for a revival in tactical asset allocation. The 2010s were, in Correa’s words, a “purely beta world”: synchronized global business cycles, compressed return dispersion and accommodative monetary policy made a static 60/40 strategy difficult to beat. The 2020s have been fundamentally different: elevated volatility, wide dispersion across asset classes and geographies and asynchronous global cycles driven by geopolitical fragmentation. “There is more alpha in tactical rotation going forward,” says Correa, “and more investors are starting to realize it.”

When liquidity is ample, a structural bid underlies markets. When liquidity is scarce, the opposite holds. Dramatic examples of overleveraged hedge funds receiving margin calls and unwinding positions make the headlines.

Liquidity conditions are critical

While long-run fundamentals endure, tactical asset allocation operates in the shorter-term world of changing multiples and risk premiums. And it is liquidity, Correa argues, that ultimately drives those shorter-term moves. His definition is deliberately broad: liquidity is the capital available and willing to flow into risk assets.

When liquidity is ample, a structural bid underlies markets. When liquidity is scarce, the opposite holds. Dramatic examples of overleveraged hedge funds receiving margin calls and unwinding positions make the headlines. But Correa notes that the genuine drivers of liquidity are fiscal policy, monetary policy, corporate balance sheets and household behaviour. The aggregate conduct of these actors shapes the liquidity backdrop far more than any single forced seller.

“That willingness to step in has been a big support for markets,” Headland notes, referring to the structural shift since 2008 in governments’ and central banks’ readiness to intervene at scale. The result is that sentiment, rather than fundamentals, increasingly shapes capital flows.

This heightened policy intervention carries risks. Sentiment-driven flows can push price multiples and risk premiums to unsustainable levels. “When it is all sentiment-driven,” Headland cautions, “there is no foundation to support the trade.”

Historical analogues

Four market episodes spanning three decades support the case that liquidity conditions, more than economic fundamentals, valuations or even the nature of the underlying shock, have been the primary determinant of market returns.

The dot-com era and the COVID-19 recovery bookend this dynamic. In the late 1990s, easy monetary conditions and financial innovation inflated a market well beyond any fundamental anchor. Equity valuations were already stretched by 1997, three full years before the peak, yet the market continued higher as speculation fueled a self-reinforcing cycle. What finally pierced the bubble was not a valuation correction but an underappreciated liquidity shock: the mass expiration of initial public offering lock-up periods flooded the market with shares, abruptly reversing the private liquidity that had sustained the boom.

Two decades later, the policy response to the COVID-19 pandemic demonstrated the opposite force. The largest fiscal and monetary liquidity injection since the Second World War turned what might have been a prolonged bear market into a positive year for equities. The sharpest economic contraction in modern history was overwhelmed not by improving fundamentals, but by the sheer volume of liquidity deployed.

The 2008 crisis illustrated the most dangerous variant: liquidity risk that is hidden until it is catastrophic. “The biggest risk normally comes from things you think are low risk but are not,” says Correa. Mortgage-backed securities appeared safe, enabling extreme leverage to accumulate across the financial system. When they proved far more volatile than assumed, that leverage amplified losses into a systemic balance-sheet recession – a fundamentally different animal from an ordinary economic downturn.

The 2022 stagflation shock made plain that the post-2008 reliance on policy intervention has limits. With inflation constraining the central bank’s ability to ease, both equities and fixed income sold off simultaneously and traditional diversification failed. When the liquidity backstop is removed, the rules of the game change.

Rotation strategies that relied solely on historical returns in economic regimes were bound to struggle, missing the liquidity signals that so often drive shorter-term outcomes.

Principles, not playbooks

The consistent advice from both Correa and Headland distills into three principles: be flexible, maintain a wide aperture and apply healthy doses of human judgment.

Flexibility matters because constraining portfolio construction also constrains alpha potential. The pension funds in Correa’s study that struggled most with tactical rotation were those most bound by their allocation targets. Their “tactical” rotations amounted to little more than glorified rebalancing. Investors anchored to static weights and a narrow set of traditional asset classes will face the same limitation in capturing the dispersion the 2020s are producing.

A wide aperture means resisting any single signal.Rotation strategies that relied solely on historical returns in economic regimes were bound to struggle, missing the liquidity signals that so often drive shorter-term outcomes. The BCA MacroQuant model aggregates hundreds of inputs across technical indicators, monetary conditions, business cycle measures and valuations, illustrating the breadth required. But even then, Correa finds the model most useful not for its aggregate score but for understanding what is driving it. “The model is an input to calibrate judgment, not a substitute for it.”

Headland concurred. The Multi-Asset Solutions Team at Manulife pairs quantitative models with qualitative insights from specialized global research “hubs.” This ensures that real-world and on-the-ground context informs decisions rather than relying solely on historical data patterns.

Capital rotation is not a science. It may be fitting, then, that in a profession where theory so regularly breaks in practice, the most dangerous words in finance occasionally prove to be the most useful. “This time is different” is rightly treated as a warning against complacency. But in the world of tactical asset allocation, the willingness to ask what is genuinely different, and act on it, may be exactly what separates those who capture the rotation from those left behind by it.

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Written by

Ryan Sheriff, CFA, CAIA, MBA, is a senior director on Manulife’s Global Manager Research team. He has over 12 years of experience in portfolio management and investment due diligence, including directing allocations across a range of public and private markets.