Related Categories
Related Articles
Articles
LIRP-environment & Cash-yields
We appear to be entering a period of prolonged low interest rates across most major developed markets. US investors are wrestling with how to adapt to this "new normal" - and how their asset allocation decisions should shift in a zero-rate environment.
Japanese investors, however, have dealt with these conditions for over 20 years since the initiation of the Zero Interest Rate Policy (ZIRP). Japan dropped rates to zero in February of 1999, and Japanese government bonds have been at around a 1% yield ever since. Zero rates are just normal in Japan.
Japan thus provides an interesting case study for how different assets performed in a zero-rate environment and which asset allocation decisions made the most sense in our view, here a brief performance-summary:
a) In terms of absolute performance, small value stocks and real estate were the best performing investments!
b) Large growth stocks and commodities were the worst performing investments.
c) Bonds, large value stocks, and small growth stocks performed in between.
The outperformance of small value stocks and real estate was a sharp reversal of prior trends. Both had significantly lagged the equity market in the 1990s. Small value stocks were out of favor as investors chased large growth stocks during the technology bubble, and real estate was still reeling from the major collapse in real estate prices that began in 1990.
Japan: Hight Debt/GDP level
------------------------------------
Despite major concerns over Japan's debt/GDP levels and bond yields starting at 1.4%, Japanese bonds returned 1-2% over the period with almost no volatility, negative correlation to equities, and a Sharpe Ratio greater than one. Commodities, the only asset which does not produce cash flow, returned basically zero real returns over this period during which there was no inflation in Japan.
Diversification benefits to equities
------------------------------------------
Only bonds and foreign exchange markets offered meaningful diversification benefits to equities, with real estate and commodities returns highly correlated to the stock market.
Do Bonds still make sense (in a ZIRP-environment)?
--------------------------------------------------------------
In a zero-rate environment, it would have been easy to declare the death of bonds as a diversifying tool. But while measly yields correctly portended low returns from bonds, they did not mean that bonds lost their role as effective diversifiers. In fact, the negative correlation of Japanese government bonds with Japanese equities was stronger than the same relationship in the United States over this period. Owning bonds in a portfolio would have significantly reduced drawdowns and volatility in the Japanese example, something to keep in mind as we now read hot takes about the death of the 60/40 portfolio.
The performance of Japanese banks was also quite interesting. Japanese bank stocks did horribly, as banks found themselves stuck with massive portfolios of zombie loans at the start of the period and were unable to make much money in a zero-rate environment.
...and NOW comes the MOST INTERESTING PART (so my view)
--------------------------------------------------------------------------
What's perhaps MOST INTERESTING about the performance of these different asset classes is that they were nearly perfectly predicted by the yields of the different asset classes in 1999. Below are the cash yields on each asset class at the start of the period and the subsequent 20-year returns.
Source: Capital IQ. Stock yields in Feb 1999 are calculated from the unlevered FCF yields on all listed stocks above/below USD 2bn in market cap for large/small stocks respectively. Value is the 20th and growth the 80th percentile breakpoint within those two universes. Bonds use the bond yield. Real estate yield is the Japanese cap rate from ARES, which is about the same as the J-REIT cap rate from Sumitomo Mitsui Trust Research Institute.
Conclusion - Japanese experience
In retrospect, with basically zero GDP growth and zero inflation, we might expect entry yields to dominate outcomes over such long horizons. And it is remarkable how highly correlated the returns were with the yields at entry. Apart from Japanese banks and Japanese bond returns, there was no clear relationship between any of the asset classes' relative performance that could be attributed to the prolonged zero-interest environment. Instead, entry valuations were highly predictive of actual outcomes in our view.
Info: How to Calculate Cash Yield
To calculate the free cash flow yield of a stock, you need to know how much it would cost you to buy the entire company rightnow (market cap). The current price of the stock multiplied by the total number of shares available.
If the company has 10 shares available at USD 1,000 apiece, the market cap is USD 10,000. If the company has USD 200 in free cash flow last year, the cash yield is USD 200 divided by USD 10,000, or USD 20 per USD 1,000 share. That's 2%, the same as the bond.
Here's the fun part. What if the price of the stock goes down to USD 800? The cash yield of the stock jumps to 2.5%. Even if the company makes the same amount of money next year, each share is worth more because it represents a larger amount of real dollar earnings!
links:
https://trendshare.org/how-to-invest
Japan-times reloaded (?)
https://mailchi.mp/verdadcap/asset-allocation-beyond-the-zero-bound
