Are we Japan (revisited)?
Almost eight years ago, I wrote how investors continue to wonder whether Japan’s economic malaise of 20 years is predictive of America’s economic future. The answer now is the same as it was then: in most ways, our situation is better.
Our economic resemblance to the Japanese was painfully apparent a decade ago, as our economy struggled to exit a deep recession brought on after we allowed a financial bubble to inflate our economy by misallocating capital to commercial real estate, single-family housing and housing-related securities. In Japan, it was a simultaneous misallocation of capital to both its property and equity markets that knocked it off its pedestal as its booming 1980s ended with a crash.
Historically, misallocations of capital have their genesis in low interest rates, which tend to precipitate excessive leveraging of the financial system, with banks at the epicenter. Everyone wins as asset prices climb, and fees and trading linked to financial transactions generate substantial profits. Then the bubble bursts, and the double-edged sword of leverage cuts the opposite way. Asset prices plunge, activity stalls and profits turn to losses. The resulting economic malaise continues until banks are no longer impaired by losses to assets on their balance sheets. Ironically, the hair of the dog in the form of low rates and time tend to be the best cures for what ails banks and the economy.
Japanese bubble was bigger
From a valuation perspective, the Japanese bubble was arguably more excessive than ours. Valuations in American property and equity markets never approached Japanese levels, even at peak valuations for the S&P 500 in October 2007 and the Nasdaq in 2000. Japanese commercial property prices fell nearly 80% from 1990 to 2005. After peaking at just shy of 39,000 at year-end 1989, Japan’s equity index, the Nikkei, is still down more than 43%. The devastation of the burst Japanese bubble is most evident when viewed through the conventional wisdom of dollar-cost-averaging—Japanese equity investors who applied such a strategy to minimize losses are underwater after three decades.
By comparison, after falling nearly 30% from their mid-2006 peak through 2011, single-family home prices in the U.S. slowly recovered, surpassing their former peak in mid-2016 and rising an additional 15% since then, according to recent S&P/Case-Shiller data. Commercial real estate prices have similarly recovered, albeit rising at slower rates than before the Great Recession. A recent survey by global property advisor CBRE found cap rates—operating income relative to value—for commercial real estate assets in the U.S. were broadly stable in the first half of 2019, aided by moderate economic growth, low inflation and falling interest rates. For offices, cap rates ranged from roughly 6% to 9%, attractive valuations in the context of a 10-year Treasury yield currently trading below 1.70%. Finally, while the S&P fell 58% from its October 2007 peak to its March 2009 low, it has long since recovered to new highs and recently has been trading around 3,000, up 90% from its 1,576 intraday peak in October 2007.
Our demographics are more favorable
A key reason U.S. equities avoided a second “lost” decade for returns was the early and dramatic responses to the financial crises of the past decade. The combination of a prolonged federal funds target rate at effectively zero and large asset purchases by the Federal Reserve helped recapitalize banks and incentivize risk. Layered over this was an expanding U.S. population, thanks to both natural and immigration growth. Japan, on the other hand, was very slow to react when its bubble burst 30 years ago, and by the time it did move, the weight of its demographic drag was too heavy to overcome. Indeed, Japan continues to stare into a demographic abyss, with its population anticipated to shrink by 25-30 million over the next 30 years. Despite the current immigration dust-up, culturally, America has a tendency to embrace foreigners as its own, albeit with what can be a generational lag. Japan is notoriously xenophobic and insular.
Yet, these key differences, as well as the prospects for equity investors, offer little solace to traditional fixed-income investors staring at historically very low U.S. interest rates. Pensioners in the U.S. who have saved for retirement are bemoaning low interest rates as a penalty for lifetimes of frugality—the same lament heard in Japan, where the 10-year Japanese Government Bond yield has traded on a downward curve below 2% for 20 years and, since the start of this year, has been trading at a negative yield. Low rates and time may be the ultimate cures for our economy, but they are the bane of retirees who need income now.
It’s all about investment options
For U.S. fixed-income investors, the resemblance to Japan ends with a comparison of the respective bond markets. The U.S. market offers a range of options unavailable to Japanese retirees, who remain captive to low and even negative nominal yields. According to Japan Securities Dealers Association statistics, Japanese corporate bond issuance is dwarfed by government issuance, meaning Japanese investors don’t have much access to credit sectors, i.e., investment-grade corporate, asset-backed, high-yield corporate and emerging-market bonds, that are available to U.S. retirees. These sectors comprise more than 30% of U.S. bond issuance and provide a possible avenue to escape the “financial repression” of low U.S. Treasury yields. These credit sectors have not fully participated in the recent Treasury bond rally, in part because much of the rally comes from global growth concerns that don’t prevail as much in the U.S. as they do elsewhere, particularly Europe.
Japan’s problems of the past three decades have been uniquely its own, while the slowdown in Europe, which has seen negative sovereign yields proliferate, suggests the risk of continental recession and potential deflation. This has created a level of uncertainty for global equity investors that exceeds anything experienced in the rolling crises of the prior two decades (Tequila, Asian, Russian, etc.). In the U.S., the fortunes of corporate credit investors are highly correlated to the fortunes of equity investors during times of crisis. But we are not in crisis here at the moment. So what to do? Short-term, given the uncertainty associated with Europe, investors may wish to keep their powder dry and emphasize capital preservation. Longer-term, credit sectors and relatively attractive positive yields in the U.S. bond market may offer fixed-income investors a way to avoid turning Japanese in their annualized returns.