• In July, financial markets received a stark foreshadowing of the future. Germany’s 10-year bond yield dipped below the European Central Bank’s deposit rate for the first time. The spectre of Japanification has taken its grip on Europe and investors need a mindset change.
• By drawing from lessons of the past and adopting unconstrained and flexible solutions, they can evolve alongside the transforming investment landscape.
The parallels between Japan’s plunge into the abyss of stagnant growth and elusive inflation and Europe’s current predicament are inescapable. And, in an ironic twist, as gloom descends over the eurozone, Japan appears to finally be lifting itself from deflationary quicksand.
Meanwhile, across the pond, the US economy may have gotten as good as it gets, as the Federal Reserve prepares to slice rates for the first time in a decade. Fears around trade tensions and concerns over the robustness of the global economy continue to cast doubt over the longevity of US economic expansion. It is not only Europe that could feel the cold wind of economic anaemia, but the entire developed world.
Boom to bust
Japan’s zombie decades were preceded by classic market euphoria. By December 1989, the benchmark Nikkei 225 stock average had scaled nearly 39,000. But by 1990, the market had a catastrophic stall, shedding $2trn by the end of the year. The party was well and truly over.
The period’s spectacular indulgence was matched only by eye watering asset prices. At the apex of property valuations, the Imperial Palace was considered more valuable than France. And it was said if you were to drop a ¥10,000 note in Tokyo’s Ginza district, it would be worth less than the scrap of ground it graced. The subsequent bust and fluctuation of asset prices unmoored the entire macro-economic system and sent Japan drifting toward the economic doldrums.
Japanification is not just another piece of jargon in the economic lexicon. It has deleterious real-world implications. Decades of economic stagnation leave deep psychological scars – our horizons are shaped by the past. Post-bust, the attitude in Japan was that tomorrow always looked a little worse than today. A lack of faith in the future dried the arteries of the financial system: banks wouldn’t lend; consumers wouldn’t spend.
Bond bears get frozen
For investors, Japanification has equally serious consequences. Japanification implies low rates are not a fleeting anomaly, but rather a new normal investors must come to terms with. For the bond markets, Japanification was catastrophic. Bond yields were driven into a permafrost and Japan became a graveyard for global fixed income bears.
Our Global Total Return Solutions teams sit opposite the economists and investors foreseeing a bear market in developed countries. As Japanification beds in, they expect rates to remain low.
In the current environment of expected higher rates, investors’ first instinct is often to shorten duration, to minimise the risk to portfolios. However, we think differently. Longer duration can deliver value and help manage overall portfolio risk.
Against the herd
Indeed, much of the sovereign bond world is already suffering from Japanification. In such an environment, the opportunity cost of holding cash will remain very high, as central banks maintain accommodating policies to support growth. This stance will be supportive for long-term bonds.
The Japanese experience demonstrates clearly that investors opting for cash because of low long-term yields lose out over longer timeframes. Over 15 years to the end of 2016, the yield on JPY cash was on average 0.24%, versus 0.92% for JGB 7-10y, a relatively small pickup at first glance for long-term bonds. But the difference in total annualised returns has been significantly higher, with an annualised 2.44% for JGB 7-10y against just 0.34% for cash.
The pivot of monetary policy from the US Fed and the ECB to a dovish stance will influence the future path of policies and have a significant impact on financial markets. Hence, it will force market participants to keep or add morerisky assets to avoid the monetary forces of financial repression.
Flexible in fixed income
With rates at artificially depressed levels, equity allocation should be very tactical depending on growth trend, as valuations are becoming of less importance. However, this increased risk stance can be implemented through some ‘carry’ assets in fixed income markets, via credit and emerging market debt in foreign currency.
Investors should also consider dividend stocks. They should be less at risk of a temporary interest rate repricing and offer a real medium to long-term alternative in this low interest rate environment.
Japanification is not coming; in many ways it has already arrived. In this new world of anaemic growth, low rates and unsupportive demographics, investors need a mindset change and to draw from lessons of the past. This means adopting unconstrained and flexible solutions that can evolve to a transformed investment landscape. At SYZ, we manage globally diversified portfolios with innovative strategies to protect capital and grow wealth in an intelligent and sustainable fashion.
Luc Filip is the Head of Investments at Bank SYZ