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Sunday 2 October 2011

A Yen For Yield

Retirement Nirvana Postponed

As countries have squashed their interest rates down over the past few years it's had the nasty consequence for millions of people approaching retirement of pushing back that nirvana of non-working bliss ever further into the future. By attempting to stimulate economies, by turning the lenders of last resort in free money machines, annuity rates – the interest received on retirement pots – have fallen, often quite dramatically.

When this happened in Japan the net effect was an extraordinary quest for a higher income in the most unlikely of places. Now, as the irrestistable force of the Boomer population moves inexorably into its retirement and is faced with the unmoveable object of yields on their investments that wouldn’t feed and clothe an anorexic sparrow on a crash diet, we’re likely to see yet another set of equally unintended consequences. If you want a trend to follow then don't bother with gold: look for yield.

A Demographic Downturn

In Looking For A Demographic Dividend we showed that there's a scarily good correlation of Japan’s nineties stock market collapse with the onset of the retirement of the bulge of Japanese workers. Even bearing in mind that correlation isn't causality, the initial signs also suggested that we’re seeing a similar effect in the United States: the retirement of Boomers is leading to an outflow of funds from riskier stocks into supposedly safer assets like government bonds, and this is, in itself, sufficient to explain the lack of market growth over the past decade. In this view everything else is really just noise which is masking the underlying signal of Boomer retirement.

When this happened in Japan the authorities reacted to economic downturn by depressing interest rates to stimulate the economy so that the return on government bonds fell quite dramatically. This, in turn, led investors to turn away from the safety of bonds and to start looking for real income in the most unlikely of places: the international currency markets. The creation of the so-called yen carry trade, where waves of Japanese money from ordinary folk flowed into higher yielding currencies was one the odder consequences of this quest for a liveable retirement income.

A Valid Analogy?

Now, of course, the parallels between the Japanese experience starting in the early nineties and that of the developed West starting at the beginning of this century are too obvious to go without note. In both cases a stock market and property boom came to a dramatic end. In both cases central banks reacted by squeezing down interest rates to near zero. In both cases there are a lot of people rapidly approaching retirement age who need a substantial income from their investments in order to fund their latter years.

Unfortunately, just because we can see an "obvious" parallel doesn’t mean that these situations are identical: analogies are a poor basis for detailed analysis, although they’re often suggestive of lines of enquiry. Japan is a special case: its economic management in the wake of the economic crisis was poor, its social custom of deference to elders has delayed important and necessary structural changes and its fierce dislike of immigration has made it difficult to manage the decline of the working population. However, there are also significant differences because, at the start of its crisis, Japan had an excess of savings, unlike the West now:
“By this point [the mid-1980’s] the economy had matured, and household consumption should have begun to replace corporate investment as a source of new aggregate demand. This, however, did not happen. Demographic factors, poor corporate governance, official intransigence, and other forces prevented the private-sector savings rate from falling and thereby left Japan saddled with much more capital than it could reasonably expect to employ within its own borders.”
The possibility that the underlying issue is really demographics and not financial mismanagement can’t easily be resolved one way or another, although a startling model from Zheng Liu and Mark Spiegel of the San Francisco Fed suggests that demographic trends can predict future US market price-earning ratios and that:
"Real stock prices follow a downward trend until 2021, cumulatively declining about 13% relative to 2010. The subsequent recovery is quite slow. Indeed, real stock prices are not expected to return to their 2010 level until 2027. On the brighter side, as the M/O ratio rebounds in 2025, we should expect a strong stock price recovery. By 2030, our calculations suggest that the real value of equities will be about 20% higher than in 2010".
Which, as "brighter sides" go, isn't the sunniest I've ever heard, especially for people retiring soon.  Előd Takáts found a similar result when he looked at the effect of ageing on house prices.  Nonetheless, even if the problem Japan faced in the early nineties was different from the situation in the developed world now the response was, from the perspective of putative retirees, very similar: near zero interest rates.

Boomers Bust?

The artificial compression of interest rates in the attempt to boost consumer spending and drag the world out of recession has had the effect of transferring wealth from savers to borrowers: a thirty-something family with a mortgage is being subsidised by retirement couples with net savings. There’s an argument that this is palpably unfair, but there’s another one that it’s the selfish retirees who’ve got the world into the mess it’s in, and the younger generations who will have to fix it. It’s a moral issue, not an economic one.

Still, the Japanese example suggests that people won’t simply sit back and accept an impoverished retirement, but will go out and look for greater income, even if it means investing in countries they can't even pronounce, let alone point out on a map. With the lenders of last resort – the central banks of the leading economies – collapsing the yields on the supposedly risk-free assets of government bonds there’s almost certainly going to be an unintended consequence: money will flow into higher yielding, more risky assets. In fact this is probably already happening.

The Search for Yield

Potentially there are many problems with this for pensioners and economies. This will be hot money: these aren’t going to be buy and forget investments. We saw ample evidence of this with the yen carry trade as trillions of dollars ebbed and flowed out of foreign currencies dependent on the risk perception of Japanese consumers: this is behavioral bias writ huge, and it can have dramatic effects on market valuations..

So, it’s going to create a tendency for even more instability in markets. Volatility is something that investors are going to have to learn to deal with, because we’re going see lots of it. And finally, investors need to look carefully for higher yielding opportunities, because these are going to be in increasing demand over the next decade or so.

Obviously this shouldn’t turn into a quest for yield at all costs, but a sensible investor in equities is probably going to be offered lots of chances to buy into higher quality stocks offering a fair yield and decent hedge against inflation as we go through various waves of psychologically mediated risk aversion. In the end buying into a company that can grow its earnings a few percent over inflation each year and translates that into equivalent dividend rises will be as sensible a retirement approach as the world can offer.

Risk and Retirement

This, of course, runs against the standard advice of moving funds into low risk assets as you approach retirement. After all, would you like to see your capital reduced by 25% just as you’re about to retire just because equity markets have sneezed? Unfortunately if the low risk assets are yielding 2% or more below inflation your income isn’t going to fund what is likely to be a long retirement.

For retirees what ultimately matters is real income, not capital. So a focus on buying proper companies with businesses that are going be hard to undermine and which pay a decent dividend may be the best way forward, along with a determination to ignore any capital volatility along the way. Of course, you wouldn’t want all of your assets in stocks, but this is likely to be a more sensible approach than just flinging your money into hot money currency trades or chasing the latest and greatest ideas of a securities industry that has a continuing mission to seek out new ways to separate us from our pennies.

This idea is touched on by recent research from the Cass Business School; which also makes the point that it's important to trade off annuity risk against a guaranteed income and the precise equity component is dependent on individual circumstances and risk aversion.  Unfortunately they then call this interesting approach "stochastic lifestyling", which is why economics professors shouldn't be let anywhere near marketing campaigns.

Whether we like it or not, governments are forcing us to take risks with our capital or suffer a long and penurious old age.  If we have to take such chances we at least ought to weight the risks in our favor as much as possible: and inflation proofed stocks held through the volatility is probably the closest thing to a free lunch left for us.  Just don't expect it to be a smooth ride if you're inclined to check your portfolio value on a daily basis ... and check out A Yen For Yield: Redux for exactly why that might be.


  1. Do you have any sense of how your strategy of buying 'proper' companies with cash flows which grow at a rate in excess of inflation, and which are able to translate this into growing dividends, would have worked out in domestic Japanese equities from 1989 to present?

    If global equities are likely to experience a similar trajectory over the next 10 or 15 years, then it will likely be accompanied by price deflation in goods, services, and other assets. Therefore, even with extremely low rates on sovereign debt, real yields will deliver more robust and stable total returns to retirees than higher yielding stocks, whose earnings and dividends are susceptible to lower prices and, potentially, lower total unit sales.

    Remember that most retirees will eventually need to eat into their capital by selling positions at some point, as inflation adjusted living expenses will exceed interest and dividend income. Therefore, probability (and liquidity) weighted after-tax real total returns to 'maturity' are much more important than 'current yield' over the entire retirement horizon.

    Check out our posts on likely future returns to stocks, and retirement planning implications, on our case studies page.

  2. That link isn't working ... probably this is correct?

    Now, I think this is well argued, and I don't disagree with the main points, but history isn't an exact guide to the future, and models based on the past aren't necessarily a good template for our future behavior, even though they're all that we have. And any philosopher can make mincemeat of an argument based on analogy.

    So, to play devil's advocate, the comparison between the extreme valuations of the Japanese stock market in 1989 and the US in 1999 aren't strictly fair: the former was massively overvalued in general while the latter's valuation was skewed by dotcom stocks. For many large US non-dotcom stocks the last decade has seen a reasonable, if unspectacular performance, if you were able to avoid the sectors heavily impacted by internet led disruption. Secondly, you can't compare the risk adverse, social compact psychology of the Japanese with the more individualistic and entrepreneurial approach of the US. Thirdly the Japanese had to invest overseas because they'd exhausted the opportunities at home; that's hardly a problem for the US. Throw in a spot of inflation and inheritance flowdown and we could see easily a different picture; and the similarity between market movements becomes a data mining accident, rather than a basis for prediction. That's the trouble with complex adaptive systems: they're incredibly sensitive to small variations in initial conditions.

    Which is not to necessarily disagree, merely to point out that anyone who adopts all-out adherence to a single deflationary point of view is probably being overoptimistic about their predictive capacities. In any case, if you're correct, I would still expect to see some behaviorally compromised market movements based on a search for yield, although I agree it will be difficult for any firm to avoid being impacted in a deflationary environment.

  3. Taking risk means taking loss.

  4. Chicken risk.

  5. Risk aversion has always been expensive, nothing new here.