Japan's Great Rotation?
Japan's public pension fund, the world’s biggest manager of retirement savings, is considering the first change to its asset balance as a new government’s policies could erode the value of $747 billion in local bonds.
Managers of the Government Pension Investment Fund, which oversees about 108 trillion yen ($1.16 trillion) in assets, will begin talks in April about reducing its 67 percent target allocation to domestic bonds, President Takahiro Mitani said in a Feb. 1 interview in Tokyo. The fund may increase holdings in emerging market stocks and start buying alternative assets.
The GPIF, created in 2006, didn’t alter the structure of its holdings during the worst global financial crisis in 80 years or in response to the 2011 earthquake and nuclear disaster. Prime Minister Shinzo Abe and the Bank of Japan (8301) have pledged to restore economic growth and spur inflation, which will mean higher interest rates, Mitani said.
“If we think about the future and if interest rates go up, then 67 percent in bonds does look harsh,” said Mitani, who was appointed in 2010 after serving as an executive director at the Bank of Japan. “We will review this soon. We will begin discussions for this in April-to-May. Any changes to our portfolio could begin at the end of the next fiscal year.”
GPIF, one of the biggest buyers of Japanese government bonds, held 69.3 trillion yen, or 64 percent of total assets, in domestic debt at the end of September, according to its latest quarterly financial statement. That compares with 12 trillion yen, or 11 percent, in Japanese stocks; 9.6 trillion yen, or 9 percent, in foreign bonds; and 12.6 trillion yen, or 12 percent, in overseas stocks.
Relative Yield
The fund, which took over management of government employee retirement savings when it was set up, returned to profit in the three months ended Dec. 31 from a 1.4 percent loss in the first six months of the fiscal year, Mitani said. He declined to be more specific. It needs to raise about 6.4 trillion yen this fiscal year through March 31 to meet payments.
The yield on Japan’s 10-year government bond climbed 3.5 basis points to 0.8 percent as of 4:35 p.m. in Tokyo today. By comparison, the projected dividend yield for the Topix Index (TPX), the country’s broadest measure of equity performance, is 2.05 percent. The Topix added 1.4 percent today.
Japan’s bonds handed investors a 1.8 percent return in 2012, according to a Bank of America Merrill Lynch Index, compared with the 18 percent surge in the Topix.
Even as shares jumped amid optimism surrounding Abe’s stimulus plans, benchmark Japanese government bond yields have remained below their five-year average yield of 1.18 percent. Benchmark 10-year yields are the lowest in the world after Switzerland and are less than half the level in the U.S.
Rates Outlook
“JGBs were how we made money over the past 10 years,” Mitani said. “The BOJ said that they are increasing buying bonds, but they’re also putting power into lowering interest rates. If the economy gets better, then long-term interest rates like a 10-year yield at less than 1 percent are unlikely.”
The five-year JGB rate touched a record low 0.14 percent last month amid speculation the Bank of Japan will expand bond purchases as part of the monetary easing advocated by Abe.
The comments by Mitani show the pension manager needs to consider higher-risk, higher-yield assets to help fund retirements of the world’s oldest population. About 26 percent of the nation is older than 65, according to data compiled by Bloomberg.
Under Mitani’s leadership, the GPIF began buying emerging- market assets in September 2011 and started purchasing shares in countries included in the MSCI Emerging Market Index (MXEF) last year. Mitani said in July 2012 that the fund was selling JGBs to pay for people’s entitlements and might consider alternative investments as it seeks better returns.
100 Years
“We haven’t changed the core portfolio for a long time so it was thought that it’s about time to review this,” Mitani said. “The portfolio was based on a prerequisite of things such as long-term interest rates at 3 percent on average for the next 100 years. Whether this is good will be a possible point of discussion.”
Holdings have been broadly unchanged since inception, when the fund was formulated with an outlook for consumer prices to rise 1 percent annually. Instead, the nation’s headline CPI has fallen an average 0.1 percent each month since the start of 2006, according to data compiled by Bloomberg.
The Bank of Japan last month doubled its inflation target to 2 percent, a level last seen in 1997, when a sales tax was increased, with no sustained price gains of that magnitude in two decades. Falling prices reduce incentives to borrow and invest in new business projects, erode tax receipts and increase the attractiveness of saving in cash rather than spending or putting money into stocks or bonds.
Topix Surge
GPIF is the biggest pension fund in the world by assets, followed by Norway’s government pension fund, according to the Towers Watson Global 300 survey in August.
Japan’s Topix Index surged 30 percent from Nov. 14, when elections were announced, through Feb. 1 on optimism the Liberal Democratic Party will lead the economy out of recession and end deflation. The yen weakened almost 14 percent against the dollar in that time, and touched its lowest level since May 2010 last week.
Even after 12 straight weekly advances, the longest streak in 40 years, the Topix is still 67 percent below its December 1989 record high.
Relative ValueAs I discussed last year, GPIF is worried about Japan's public debt and in order to solve its funding problems, it started diversifying into alternatives and emerging market stocks. Now it is considering revamping its portfolio to reflect higher inflation, moving out of JGBs and into stocks.
The measure trades for 1.1 times the value of net assets. That compares with 2.3 times for the S&P 500, 1.6 times for the Hang Seng Index and 1.9 times for the MSCI World Index. A reading above one means investors are paying more for a company than the value of its net assets.
The yen dropped 11 percent last year versus the dollar, the most since 2005. A weaker yen increases the value of exports and typically raises import costs, boosting consumer prices.
“Japanese stocks do not look expensive,” Mitani said. “We’re still in the middle of a rising stocks, weakening yen trend. It will continue for a while.”
Investors should take note of 'Japan's Great Rotation' because if you couple it with the Great Rotation going on in the United States and elsewhere, it will be a significant boost to global equities. And while some argue that the rotation out of bonds into stocks is nothing but a fairy tale, the hunt for yield is intensifying as global pension fund managers struggle to meet their liabilities despite seeing their assets hit an all-time high.
Moreover, as I've previously discussed, the seismic shift in Japan will have a profound effect on global liquidity. When central banks all pump up the jam in a coordinated effort to fight the demons of deleveraging and deflation, all that liquidity benefits risk assets like stocks, corporate bonds, and structured credit.
But with junk bonds now yielding a record low 5.9%, many global investors feel that bond party is over, and are increasingly looking at illiquid alternatives for stable yields that are not provided in bonds and stocks. It looks like GPIF is slowly heading that way too but they also need to revamp their investment policies to allocate more to public and private equities.
Nonetheless, it's still too early to proclaim the death of bonds. Lots of hedge fund managers, like Kyle Bass, are salivating at the prospect of making a killing shorting JGBs, but they should be careful as that trade has been a loser over the the last 20 years and despite all the ruckus, Japan is still struggling with persistent deflation and is vulnerable to external shocks.
Below, CLSA Asia-Pacific Markets Japan Strategist Nicholas Smith discusses the rally in Japan. He speaks with Rishaad Salamat on Bloomberg Television's "On the Move Asia,." stating that risks to Japan are externnal
And Eurasia Group's Jun Okumura discusses Japan's budget for 2013 that cuts spending for the first time in seven years, underscoring Prime Minister Shinzo Abe’s efforts to establish fiscal-discipline credentials even as he seeks to boost growth. He also speaks on Bloomberg Television's "On The Move Asia."