Every year at this time an increasing number of Australians head to Japan to ski. But it’s not only the mountains that should be attracting Australians. Australian investors should also be taking a keen interest in the factors influencing the Japanese economy and its financial policy settings as they may provide some insight into the prospects for the rest of the world.
Low interest rates are generally supportive for asset valuations and prices. Valuations are boosted by low rates through the present value calculation, and the transmission mechanism for higher asset prices is the migration of investors from low-yielding bank accounts to other assets.
It is therefore critical, when thinking about the prospects for returns on equities, that we consider the path of interest rates. This is where Japan matters. At least two of the factors that are contributors to ultra-low rates around the world today, have been in place in Japan for decades. Therefore Japan’s experience may help to understand the prospects for our own investing futures.
Consider first demographics. Years ago, I wrote about a possible correlation between the price-to-earnings ratio of the S&P500 index and the number of ‘asset accumulators’ (45-year-olds) relative to pensioners or ‘asset decumulators’ (65-year-olds). It makes sense that as the population ages and a greater proportion of investors shift from youthful accumulators to retired decumulators, that the influence on asset prices also switches from supportive to dampening or even depressing. In recent years however, even as asset decumulators have increased as a proportion of the investing population, PE’s have expanded, suggesting interest rates impose an even greater influence.
Over the next 80 years the world is going to experience the effects of a vastly different population, a population that is barely growing by 2100 and an economy that sees the proportion of the population over the age of 65 rising from 10 per cent today, to over 20 per cent by 2100.
When more people retire, the productive capacity and the output of the affected economy declines. At the same time the financial liabilities of a government obligated to support society through pension payments and healthcare increase. Lower economic output and greater debt pushes down interest rates.
If an ageing population and increasing debt is a negative influence on interest rates, then the world may be in for an extended period of low rates.
Japan offers a few clues about what we might expect.
What we know is that the growth of the working age population in Japan turned negative in 1994 – 25 years ago. In Europe, growth of the working age population turned negative only relatively recently, in 2011, while China’s working age population growth turned negative even more recently in 2015.
At the same time, Japan’s public indebtedness has been on an increasing path for two-and-a-half decades and now sits at 250 per cent of GDP, depressing interest rates there. While China, the US and Europe’s ratios sit between 50 per cent (China) and 100 per cent (USA) they also appear to be on the same path Japan began on. And slowing population growth and an ageing population in Europe and China should also see public indebtedness continue to rise.
For the last 25 years Japanese interest rates have been in structural decline. In 1999, a decade before the GFC, the Bank of Japan (BOJ) employed a zero-interest rate policy (ZIRP) and borrowing was free. Within the subsequent 24 months, the BOJ also printed Yen, purchased government bonds and flooded the financial system with liquidity in its own Quantitative Easing.
Despite the western world at the time criticizing Japan’s methods, it subsequently engaged in precisely the same course of action after the GFC.
It is important to note that despite commencing QE and ZIRP eight to ten years before the GFC, the Japanese equity market collapsed during the GFC. Indeed between 1990 and 2009, the Nikkei had fallen 81 per cent.
As the working age population in Japan continued its steady decline, Japan’s unconventional monetary policies failed to stimulate growth. Japan now manipulates not only short-term rate, but rates all the way out to ten years, in a form of yield curve control known as yield targeting. And in addition to buying bonds, the Bank of Japan also is a buyer of individual equities, exchange traded funds (ETFs) and property trusts (REITS). The Bank of Japan now owns 80 per cent of all equity ETFs.
These actions have triggered a 300 per cent rally in Japanese equities since the GFC.
Investors must seriously consider whether there is merit in the idea that China and Europe’s declining working age population and growing debt obligations also end up producing permanently low interest rates, as they did in Japan. Such an outcome could be supportive for asset valuations, notwithstanding the possibility of bumps along the way. And if eventually, direct central bank buying of equities and index funds is repeated outside of Japan, equity investors may further benefit.
While I am almost certain contemplating the history of Japanese population growth and debt mountain will not provide for a tax-deductible ski trip to Japan, investors should nevertheless think carefully about possibility that history repeats. Deep market corrections could be few and far between but when they do occur must be seen for the opportunities they are.