As promised in last month's letter, now we will take a look at a comparative study between Japan and the U.S., what this means potentially for the economy moving forward, and most importantly, what it means for what you should look for in future investments.
The prevailing sentiment I have heard restated over and over in meetings with other fund managers, financial advisors, and bankers is “lower for longer.” This is of course referring to the FED interest rate policy, but the implications are much further reaching than that. With interest rates all over the world hitting record lows, and in some cases even turning negative, this creates a serious practical problem for the everyday investor trying to save for their retirement. In order to achieve a rate of return they need to meet their goals, they are continually pushed out the spectrum of risk but now, the average investor is not being rewarded at proportionally high levels for that risk. So what does the average investor do? Sophisticated (or accredited investors) have had access to alternative investment structures such as hedge funds, private equity funds, and real estate partnerships for years, but if you lack the capital or legal requirements to access such vehicles what is available? Well, it seems the market has spoken when it comes to solving this gap in required investment returns in the form of what’s known in the industry as a 40 Act Fund, and more commonly now as a “liquid alternative.” These liquid alternatives are essentially hedge fund type products that have been packaged up in the form of a mutual fund or ETF, and the market appetite for them has been enormous. The liquid alternative industry popped up almost overnight after the financial crisis, and now stands somewhere in the neighborhood of half a trillion dollars. For the reasons I will outline next, it is very clear that going forward capital will have the best chance of protection and growth in the right alternative investment vehicles, but emphasis will need to be put on the due diligence of the investment to ensure that it matches the specific needs of the investor, and it is run by managers who, like us, are looking around the corners in the market and incorporating their findings into the investment decision making process. If one lesson can be learned from others in the industry in the first half of 2016, it is that chasing trends is a quick way to lead to under performance.
Returning to low interest rates, I will start with a brief history of Japanese monetary policy beginning at the end of the last century. In 1998 the Bank of Japan (“BoJ”) (the equivalent of our Federal Reserve) became its own independent entity, separate from the Japanese government. The economy had been a dismal state for almost a decade with the growth rate from 1993 to 2003 hardly over 1% accompanying a slide in nominal GDP of 4% from 1997 to 2002. To combat this, a policy of near zero and then zero percent was targeted by the BoJ for the uncollateralized call rate (the Japanese equivalent to the FED’s federal funds rate). By 2002, the BoJ had started outright purchases of equities from commercial bank balance sheets to try to provide banks with liquidity to lend and spur economic growth. However, after all of this, when the BoJ went to raise rates again in the mid-2000s, the Japanese economy went into a tailspin and almost immediately fell into another recession.
To summarize, the historical consequences of the quagmire that has been Japanese monetary policy over the last couple of decades has been largely two fold. First, the economy has been placed in a prolonged state of deflation, which has the feedback effect of ensuring that rates remain low or zero, leaving no room to lower them further to kick start growth. Second, the BoJ has lost a lot of credibility to the point that now, financial markets largely price in that any move by the BoJ will have little to no effect on the Japanese economy in either the short or long run. On a note that only economists are likely to find interesting, in my research for this letter I found a study that evaluated Japanese monetary policy over the past few decades, and used several economic models to determine how closely (or, as was more often the case, how far way) the policy that was conducted was to the economic optimal. For uncollateralized call rate optimization, they used the Taylor Rule method, which in theory can be used to calculate such an optimal rate, and found for Japan in the late 90s and early 2000s, this estimation was negative.
Unlike the policy rate, the estimation of the optimal rate does not have a lower bound at 0%, meaning most economists would interpret this as a signal for a zero interest rate policy (“ZIRP”). However, in light of what we have seen in bond markets recently, it could also mean that a negative rate is in fact the economic optimal, and market forces have found a way to price the bonds as such. Overall, this is a curious conclusion because the most literal economic interpretation of negative interest rates is that investors see liquidity as a negative thing and are willing to pay to not have it.
As a preface to the next area of comparison we will look at, I would like to do a quick introduction of economic theory and literature. Severing as a bedrock to my next point is a study published by Vincent Reinhardt, Carmen Reinhardt, and Kenneth Rogoff in The Journal of Economic Perspectives. The study identified and measured the impact of instances where advanced economies had periods of extremely high, sustained debt as measured by debt-to-GDP. The basic idea of their theory was that a government takes on more debt to support household incomes in their economy, but because of this, consumers feel less obligated to save for retirement since the government is making promises of income and medical coverage in retirement. Since economists equate savings to real investment, as the savings rate decreases, so does real investment in the economy. With lower real investment comes lower productivity, profitability, and economic growth, and these in turn complete the feedback loop that leads the government to borrow more to replace the lost income.
For Japan, this cycle is exactly what was happening in their economy during the time period I was describing above. From 1989 to 2015 the government debt-to-GDP ratio has gone from 50.9% to a staggering 209.2%. Over that same time period, the savings rate fell from 26.6% to 6.6%, and while the Yen has recently showed some strength off of multi-decade lows, this has proven negative for the economy since it hurts the trade balance. These powerful contractionary forces have led to an increase in the sophistication and sheer volume of measures the BoJ is willing to deploy to stimulate the economy. Their current quantitative easing (“QE”) program has a purchase target of Japanese government bonds of $400 billion, but as of now, the government only plans to issue $200 billion worth of new bonds this year. Scaled relative to GDP, this QE program is equivalent to the FED having a purchase target of $1.74 trillion over a one-year period. By comparison, the most aggressive buying rate the FED has maintained, deemed “QE3,” was about $1.02 trillion per year (58.6% of the Japanese plan) and that lasted from September 2012 to September 2013. For our economy, this kicked off an unrelenting bull market which saw the stock market go up nearly 50% in the post financial crisis shake out. In short, the BoJ is reaching the end of the rope so to speak in terms of debt they are able to buy to create a stimulus which is a similar situation to what the EU is facing as well. This year alone, the European Central Bank (“ECB”) will buy up over half of the available market of EU sovereign debt, and with negative rates proliferating throughout Europe, this introduces another factor that will decrease the available supply as the ECB cannot buy bonds below -0.4% yield. To solve this problem, it has recently been revealed the ECB has started doing private debt placements with a select number of private European corporations, a move that is certainly unprecedented and that has been dubbed by some as highly controversial. For the BoJ, in addition to their bond purchasing, they are also purchasing ETFs in the Japanese stock market at a pace of $58 billion a year, up from a little over $30 billion per year rate as of their meeting at the beginning of August 2016.
The bottom line with Japanese monetary policy has been, and continues to be, that it is seeming to have no effect in correcting the economic tailspin. Contrasting with the current position in the U.S., our policy position is not as dire (we have maintained a low, but not zero, interest rate policy), but most recent economic predictions are indicating that the FED’s rate ceiling (meaning the maximum they could conceivably raise rates without instantly triggering a recession) is falling every month leaving the range of interest rate policy manipulation increasingly smaller. The other contrast between the U.S. and Japan is we have a considerably larger economy. I have yet to be able to find any data to confirm this idea, but intuitively it would make sense that we would have a longer runway so to speak with which to deal with our problems.
Despite these differences, the key takeaways remain more in line with the U.S. following Japan’s lead than learning from it. The most important takeaway for me was that there is in fact some data to go off of in the so called “new normal” state of economic affairs. Not that Japan should serve as an exact roadmap for things to come, but it does provide a set of possible outcomes that has proven very contrary to conventional economic thought. The other key takeaway was how long it can take for some of these policies to pan out. In the world today, we are becoming more and more accustomed to receiving information and feedback instantly, but in Japan’s case there was no “calling the top” moment for asset managers and thus they had to continually remain alert and responsive to opportunities as they have and continue to present themselves. It is for this reason, as was stated in our July newsletter, we continue to seek companies with low debts and high cash reserves on the long side of the portfolio, and the opposite on the short side. These companies are the most (least) attractive for acquisition on the long (short) side, and will likely fare the best (worst) in the event of a downturn.