by Asset Allocation Committee | PDF

With the U.S. dollar apparently poised for what could be a long phase of depreciation, investors are naturally looking more closely at foreign stocks for future growth.  Japan has been a prime focus, not only because it sports the world’s third-largest economy and the third-largest equity market, but also because Japanese stocks have recently performed well.  Over the last six months, for example, the MSCI Japan Index provided a total return of 17.3% (in dollar terms), almost double the return on the U.S. index.  But are Japanese stocks set for further gains over the long term?  Have Japanese stocks really overcome their long period of underperformance since the country’s “bubble economy” burst more than 30 years ago?  A close look at the Japanese economy and financial markets shows Japan has certain cyclical advantages that investors could currently take advantage of, but it is also facing longer-term headwinds that are likely to weigh on returns over time.

Countries that go through an investment bubble like Japan did in the 1980s are left with the challenge of adjustment once the bubble bursts.  Among the many possible strategies to deal with the excess investment and resulting overcapacity, the government can simply step back and allow asset prices to quickly adjust downward, putting lots of people out of work and leaving creditors empty-handed.  After the pain of the Great Depression, governments these days more often try to slow the process and spread the costs broadly.  Our analysis suggests Japan completed the slow process of repricing its assets and working through its excess investment in the early part of this century.  In the chart below, which shows the inflation-adjusted growth rate for each major category of Japan’s gross domestic product (GDP) by period, the red columns show how fixed investment swung dramatically from an average annual increase of 5.5% in the 1980s to average annual declines of 0.4% through the 1990s and 2.1% in the first decade of the 2000s.  However, the chart shows that Japanese investment finally started to grow again in about 2010 (we’ve excluded the data for 2020, since it is distorted by the coronavirus pandemic).

Besides the rebound in investment, Japan has also recently shown other improvements in economic policy and dynamics.  For example, the country has deepened its economic ties to China, helping boost its exports.  It has improved its corporate governance rules and brought more people into the workforce.  All the same, the chart above suggests why its stock market performance remained weak until recently.  As is typical for highly developed countries, personal consumption spending is the biggest driver of Japan’s economy, but the chart shows that this type of spending has been growing ever more slowly, even after investment rebounded and labor force participation increased.  This critical slowdown in consumer spending almost certainly reflects Japan’s major problem with low birth rates, a shrinking population, and population aging.  Taking a “glass half full” approach, you could say that the rebound in Japanese investment has come just in time to offset some of the country’s poor demographics.  From a “glass half empty” perspective, you could also argue that the positive impact of Japan’s investment rebound is being offset by worsening consumer spending trends.

The back-to-back problems of asset price adjustments and demographics have presented a continuing challenge for Japanese companies.  In addition, government policymakers have been unable to come up with ways to address the situation.  In some ways, they’ve even exacerbated it (especially by raising the national value-added levy, a type of sales tax).  As shown in the chart below, Japanese corporate profits have trended upward since the bursting of the bubble economy, but the average rate of increase has been anemic at about 2.5% per year, versus 7.5% per year in the U.S.

Because of its enormous economy and financial markets, Japan can’t be ignored by investors, but this analysis shows that the country continues to face big challenges to its economic growth and corporate profitability.  In the short term, we do think Japanese stocks could continue their recent short-term cyclical rebound because of factors like its corporate governance improvements, investors’ shift toward the “value” stocks that make up so much of the market, or the post-pandemic economic rebound around the world, which is boosting Japanese exports.  In the long term, however, it’s important to remember that Japanese stocks will probably continue to face continuing secular challenges from its poor demographics.

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by Asset Allocation Committee | PDF

In our 2021 Outlook, we had a forecast for the S&P 500 of 3918/4050.  Since the index is close to that level, we have received questions about whether we are expecting little upside from here or if we intend to calibrate our expectations.  This week’s Asset Allocation Weekly is a preliminary look at what we intend as an update of our forecast.

Optimism surrounding economic growth in 2021 is rising rapidly.  A number of private economists have dramatically upgraded their forecasts.  The Atlanta FRB’s GDPNow forecast for Q1 is estimating real GDP at 9.5%.  We do expect that growth estimate to decline from these levels (e.g., rising consumption will lift imports, which are a drag on GDP), but a reading above 5% is clearly possible.  There are two factors driving optimism; the first is that the virus appears to be coming under control.  The combination of widespread infections and increasing vaccinations means the U.S. is probably achieving some degree of herd immunity.  Although caution won’t be necessarily thrown to the winds, a steady relaxation of restrictions will boost services consumption.  Second, fiscal spending will tend to boost the economy.

This optimism could be misplaced.  The virus could mutate into a form that renders current vaccines less effective.  Even after the risk of infection has been reduced, it still may take some time for fear to be reduced.  It should also be noted that much of the fiscal spending is direct transfers to households instead of the government purchasing goods and services.  Although this aid may be spent, we would not be shocked to see some of these funds used for debt reduction or saving.  After all, inflation has been low, households are still over leveraged, and many households are in arrears over rent or mortgage payments.  It isn’t certain that this optimism is appropriate, but for now, the financial markets are leaning in that direction.  So, what do we know so far?

We are seeing a drift away from sectors that benefited from the pandemic to those who will do better in recovery.  The easiest way to see this is by comparing the S&P 500 to its equal-weighted compatriot.

In the long run, the equal-weighted index outperforms the capitalization-weighted index.  For example, from 1990 through 2020, the former rose at a compound annual growth rate of 14.3%.  Over the same time frame, the latter rose 12.5%.  However, there are occasions when the capitalization-weighted index outperforms.  For example, during the tech bubble, it did better than the equal-weighted index.  It also outperformed during the pandemic.  As the above chart shows, as equities fell due to the pandemic shutdown, the capitalization-weighted index did better.  The difference line on the lower part of the graph, which represents the spread between the capitalization-weighted index and the equal-weighted index, widened in favor of the former.  We have put two boxes on the chart.  The first, which shows the late second quarter, shows the spread narrowing as the economy recovered.  The second box is the period after the election.  After the election, optimism over additional fiscal stimulus rose.  In general, what we are seeing is that the equal-weighted index tends to perform better in the currency cycle when economic expectations improve.

Commodity prices are rising.  The five-year change in the CRB index is rising rapidly.

The yield curve is steepening.

This chart shows the spread between the 10-year T-note and fed funds.  Inversions (a reading less than zero) is a consistent indicator of recession.  As this curve steepens, note that in the last four business cycles, the spread exceeded 200 bps.  If this were to occur again, the 10-year T-note yield would exceed 2.00%.

So, what does this all mean?  First, we might be in a situation where the S&P 500 doesn’t move much higher from here but sectors and areas of the market that have lagged show improvement.  Investing performance may be less about owning an index than focusing on other areas of the market.  Second, areas outside of stocks are poised to do well―commodities, for example.  Third, the risk to equities probably comes from rising interest rates.  At the same time, not all parts of the equity market struggle with higher rates, and these areas should show promise.

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by Asset Allocation Committee | PDF

The steady rise in the 10-year T-note has started to raise concerns about the impact of higher yields.  This week’s report will examine what impact the steady rise in yields may have on the economy and markets.  Essentially, the issue at hand is if, how, or when the FOMC will act to intervene in the rise of yields.  We suspect there are two factors that would sway policymakers.  The first would be if the rise in yields had an adverse impact on housing.  The second is if it would trigger a problem in the financial markets.  Equity markets are one potential clue; the other would be credit markets.  We will discuss housing and equity markets in this report, and cover credit spreads in the accompanying chartbook.

For starters, it makes sense to gauge the situation of current yields.

The two most important variables in the model are fed funds and the 15-year average of the yearly change in CPI.  The latter acts as a proxy for inflation expectations.  We add the yen’s exchange rate, oil prices, German Bund yields, and the fiscal deficit scaled to GDP.  Although yields are rising, they remain below the fair value yield, which is currently at 1.42%.  Note the red ellipse on the chart.  At that level of overvaluation, yields would be 1.90% to 2.00%.  In recent years, this level has been the peak yield.  For now, yields remain below their fundamental value but a rise to 2.00% is not out of the question.

If yields continue to rise, what are the risks?  For the real economy, the primary concern would be residential real estate.  Mortgage yields are closely tied to the 10-year T-note spread and rising yields could make housing less affordable.

The housing affordability index consists of mortgage rates, home prices, and household income.  The higher the reading of the index, the more affordable residential real estate is for the median buyer.  A simple model of this relationship suggests that a 2.00% 10-year yield would reduce the affordability index to 162.1.  That would be a rather modest decline and probably not one significant enough to warrant intervention by the FOMC.

Finally, there is a well-known relationship between P/Es and long-term interest rates.

This chart shows the cyclically adjusted P/E (CAPE) and the 10-year yield.  Although the CAPE is elevated, some of the lift is a function of lower yields.  It is important to note that some of the rise in long-duration interest rates is a function of stronger economic growth.  Better economic growth is affecting earnings.  Our most recent iteration of our earnings model generates S&P 500 earnings this year of $153.72, up from our initial forecast of $147.84.[1]  Earnings per share is being adversely affected by a rising divisor, a function of new share issuance.  Rising rates are triggering a decline in the fair value multiple to 25.4x (from 26.9x), yielding a fair value of 3905, which is modestly below the low end of our previously forecast range of 3918 to 4050.  A rise to 2.00% on the 10-year would reduce the fair value P/E to 24.8x, ceteris paribus.  Overall, though, we remain favorable toward equities simply due to the outstanding level of liquidity available to financial markets.

In closing, what form would Federal Reserve intervention take?  The most aggressive action the FOMC could take would be yield curve control, where the central bank would set the rate for Treasuries and allow its balance sheet to expand and contract to accommodate the fixing of interest rates.  There is, in our estimation, a good chance this will occur at some point. But the above analysis suggests that, barring a crisis, it would probably take a yield above 2.00% on the 10-year Treasury based on current conditions.  Will we reach that level?  Probably not in the near term.  Therefore, we expect the FOMC to continue to talk about policy accommodation for the foreseeable future but avoid the topic of yield curve control until forced to act.

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[1] This earnings number is based on Standard and Poor’s calculation method, which is more conservative than the widely reported Thomson/Reuters earnings.  In general, the former is usually about 7% less than the latter.