A housing market implosion, banks teetering on default and merging, interest rates hitting rock bottom and the government stepping in to try to quell the storm. Sound familiar? This was Japan during the 90’s and even early 2000’s, what has been dubbed the “lost decade” in Japan. In the US we have had some people use this term for the economy in between the bursting of the dot com bubble and the financial crisis. Although there are fundamental differences between the two crises in Japan and the US, there is one thing that remains common today: rock bottom interest rates.

It’s especially relevant this week as the Fed meets to likely cut interest rates again on Wednesday. With the Fed Funds Rate, the lynch pin of all interest rates in the economy at 2.5% currently, given a cut, there will be little room to maneuver to head off a potential downturn in the coming years without resorting to little understood policy measures like quantitative easing.

For this reason, it isn’t outlandish to predict that given the continued low inflation we are experiencing across the rich world, we could be in for a long period of low interest rates. This will have huge impacts on everyone, especially those who are about to retire or are already retired. It will affect their asset allocation and the types of risks that they may have to take given a low interest rate environment. Given this, I would like to take a look at how Japanese households have reacted to a period of 20 years of low rates and what the future for US savers may look like.

Turning Conventional Wisdom on it’s Head

As I pointed out in a previous post it used to be that as you got older, the more bonds you needed to hold in your portfolio. The old adage was that you subtract your age from 100 and that was the percentage of equity you should be holding in your portfolio. However, with people living longer lives and rates at long term lows, it may not make sense or even make it possible to retire, if your fixed income portfolio is only yielding 3% max. Hence why many money managers and advisors are counseling those about to retire to hold more equity. So let’s take a look at what happened in Japan and how households reacted and shifted their assets in response to a period in that country where they have had low rates for almost 20 years.

Starting with the rates themselves, when the housing market imploded in the early 90’s the bank of Japan dramatically cut rates throughout the 90’s to come to near 0% rates by the year 2000.

Source: Schroders

When we look at US rates since 1970, we see a similar pattern:

Source: St. Louis Fed

As we now know, the low rates in the early 2000’s mixed with the rocket fuel of securitization, created the destabilizing scenario that sewed the seeds of the housing crisis in the US and plunged the world into an economic downturn.

This time is different though, at least in the housing market, lending standards have been reigned in. We don’t (yet) see the excesses of NINJA loans (No Income, No Job or Assets) or excessive leverage allowed to buy homes. With rates so low though, even with the drop off in the stock market during the crisis, investment had to flow somewhere, in the US that meant that investment flows poured back into the stock market. The results of which over the past 10 years you can see below.

Source: St. Louis Fed

Despite the day to day gyrations and last year’s drop, the index has more than tripled in the past 10 years.

Similar to the housing bubble experience in the US, Japan experienced an “everything bubble” in the late 80’s and when it burst in the 90’s everything crashed with it, including equity prices.

Source: macrotrends

That looks bad, especially that equity prices still have not regained highs seen in 1990 to this day. When you ignore the 1990 crash and look at the last 20 years though, it looks a bit similar to what we have seen in the US in terms of the trend.

Source: macrotrends

Compare the run up in the S&P 500 below over the past 20 years.

Source: macrotrends

Obviously the S&P run up was much greater since 2009. There are a number of factors for this besides the low rates: innovation, companies going global and higher profit margins due to cheaper production through international supply chains. The results are much the same when you compare Japanese and US returns on equity to other asset classes. Although bonds held steady in terms of price in Japan and managed a decent return in the US over the past 10 years, the place to be was equity in this low rate environment.

Putting the returns from equity, bonds and real estate together in one chart, you can see this result visualized below.

Source: schroders

Over the 20 previous years, equity in Japan worked out to a 3.6% annualized return. The S&P over the same period managed to return about 5.7%. Clearly equities were the way to go in Japan, considering flat bonds and strangely an overall housing market that continues to fall in value as the country shrinks in population.

Is the Future International?

So far we have looked at just the local interest rates and the local returns of each respective market. Money is international though, and Japan and the US are two large open economies. Residents and companies have the option of taking their capital outside the country.

When you start to look at the holdings of Japanese households you can see two big factors pop out of their evolution below.

Source: Schroders

That is, that Japanese households hold a very high proportion of cash compared to other assets. This may have to do with a fear of deflation: where holding cash means it becomes more valuable over time.

It could also be a risk averse cultural preference. When we look at the cash holdings of Japanese households compared to other countries, it is much higher.

Source: schroders

Intuitively, this also makes sense because if bonds yield nothing, real estate is falling and equity is choppy, holding cash makes more sense.

Still, the growth has to come from somewhere or people will never retire, that growth has come from investing overseas. Take a look below at the ramp up in foreign investment by Japanese households and you will see that foreign equity is playing a key role as part of local people’s portfolios.

Source: schroders

Although the proportion of household financial assets in foreign stocks is still small, it tripled since rates have been low or negative in Japan.

I would even argue that much of the growth in the S&P 500 has come from moving into foreign markets where there are more growth opportunities. Currently the S&P 500 derives about a third of its revenues from overseas.

Source: Phillip Brzenk, Seeking Alpha

Here is where the future may lie in a low rate environment for the US. Much of the public and the media has been fascinated with AI and the trade war. I think there may be a case also for going back to that old growth story: emerging markets. This sector could be a future source of growth in dollar terms for the following reasons:

• Housing has offered the best returns, even better than stocks when you factor in leverage, but how long can this continue? Especially given the low birth rate in the US and the recent hostility towards immigration. Demographics may take hold and pull real estate in many areas down in the long term as they did in Japan if the population shrinks.
• From the ashes of the dot com implosion and the myriad of companies with sky high hopes have come a few dominant tech companies. Will the FAANG be enough to propel the entire US equity market? I’m not so sure.
• Even the tech companies are going global. Much of the talk surrounding Libra by Facebook which was lost in the media cycle was that it’s actually geared towards users in emerging markets and the other half of the world outside the rich one which will be coming online in the coming decades.
• Demographics are on the side of emerging markets, countries in Africa, the Middle East and Asia are expected to boom in the coming decades as a flurry of young workers in their prime come into their own.

Conclusion

Despite the trade war and the hostility to immigrants now, the future in a low rate environment according to the lessons from Japan, may be to start shifting more assets not just to equities, but emerging countries and rapidly developing economies in general. Large companies will continue to increase their revenue from overseas but soon it may be investors who have to follow the growth by gradually moving their investments overseas. The consequences of these shifts could soon change the world and the relationship we have with emerging economies.

The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.