Ever since the financial crisis, and at the very latest since the euro crisis, when the issue of high government debt became virulent, the “Japanese disease” has been on the minds of financial professionals. Japan has been living with rampant government debt combined with sustained low interest rates for more than a decade now. And we in Europe must now adapt to this regime as well.
Perhaps my perception is not representative, but I have the impression that this phenomenon is discussed often and intensively. When discussed in the context of our own situation, it usually revolves around the sustainability of high government debt levels or whether, based on similar demographic trends and an aging society, we are threatened with similar conditions in the long term. A quick aside: This will not be a problem as long as we pursue an active immigration policy.
As exciting as such fundamental debates may be, they revolve primarily around political-strategic considerations. They are of only limited help for the concrete problems facing institutional investors today. However, we believe that the parallels between the situations in Japan and Europe do offer important insight for institutional investors.
To put this into perspective, let’s look at the situation of the Japanese Government Pension Investment Fund (GPIF). The GPIF manages assets of approximately €1.2 billion, making it one of the largest, if not the largest, pension funds in the world. For us, it is a representative example of the situation of long-term institutional investors in Japan.
Until 2014, the GPIF held a government bond allocation of approximately 60 percent in its portfolio. In the spring of 2012, the yield on ten-year Japanese government bonds fell below one percent. Owing to the growth-oriented policies of the Abe government and the central bank, this yield has since steadily fallen into negative territory. If interest rates remain permanently around zero, this inevitably leads to investment pressure for investors. The question now is how quickly investors become aware of the situation and how they react.
In 2014, the GPIF decided to make the target allocation of the overall portfolio significantly more opportunity-oriented: The share of domestic bonds, predominantly government bonds, was reduced from 60 to 35 percent, while simultaneously increasing the equity allocation from 24 to 50 percent. Admittedly, implementing a target allocation for equities of 50 percent seems extreme, but the direction is clear: interest rates at zero percent require a significant rethink and a shift in investment policy among investors. There’s hardly any way around this truth.
Now that the 10-year yield in Europe has slipped back into negative territory, European institutions must also slowly come to terms with the idea of having to manage their investments in a regime of extremely low interest rates for longer periods of time. And they will have to decide what this means for their strategic allocation. If we assume a – quite ambitious due to historically high valuation levels – return corridor of four to six percent in the equity markets, it becomes clear that the allocation to risky assets must be significantly increased. And this is precisely where we should learn from the GPIF’s experience. Moving up the risk ladder increases the potential for returns, but with it come the risks. Accordingly, the GPIF’s quarterly returns have been significantly higher on average since 2014, but portfolio volatility has also increased significantly. In the fourth quarter of 2018, the GPIF eventually experienced a record loss of 9.1 percent. As can be seen from the corresponding quarterly report, the equity allocation was completely exposed to the market turmoil. Ultimately, the equity drawdowns of that quarter have recovered, leaving behind just one more correction that we might soon forget. But I wonder, what would that portfolio have looked like, if the correction had turned into a full-blown crash?
The lesson to be learned here is simple. If, as we assume, long-term portfolios need to be positioned to offer significantly more opportunities in the future, then it is imperative that this is accompanied by consistent risk management. Not a single pension needs to die by the “Japanese disease.”
