Unconventional central bank policy

Central bank policy is inherently a product of trial and error. We saw this most vividly when the Bank of Japan (BoJ) introduced quantitative easing (QE) in the early 2000s to fight deflation, and again when the Federal Reserve (Fed) took a similar policy approach during the 2008 financial crisis. Since then, QE has transitioned from an unconventional experiment to a cornerstone of fiscal policy, alongside other policy tools (less widely adopted) such as negative interest rates and yield curve control.

The details varied, but In essence, these policies were either accommodative or restrictive. Might there be another path for monetary policy? Recent developments suggest there is.

The BoJ is a case in point. In March the BoJ decided to end its negative interest rate policy, yield curve control and credit easing while continuing with QE. The move – pairing a more restrictive stance on rates alongside QE– signaled a pivotal shift from historical precedent and conventional wisdom.

Traditionally, central bank policies tended to be directionally aligned in implementing restrictive or accommodative measures. The new approach also suggests the possibility of nudging interest rates higher across the yield curve to achieve a balanced, or neutral, monetary impact.

The BoJ’s shift has undoubtedly caught the attention of the Fed, which has adopted its own mixed policy mirroring aspects of the BoJ's latest moves. On the one hand the Fed looks to maintain elevated rates, with the market now pricing in just one rate cut in 2024; on the other hand the Fed signals that it is tapering the pace of its quantitative tightening (QT).

The Fed’s mixed policy could have profound implications for the U.S. financial landscape. It opens the door for pension plans, commercial banks and insurance companies to benefit from higher interest rates, while potentially tempering speculative excess in sectors such as housing and real estate. A new monetary policy approach that includes both accommodative measures and a higher interest rate could have a significant impact on capital markets. The aggregate impact could be a high-for-longer interest rate environment coupled with a benign, positive growth environment, which could lead to renewed advantage for risk assets (equity and credit markets).

Inflation and corporate reforms support Japanese equities

We turn first to Japanese equities.

On December 29, 1989, the Nikkei 225 Index closed at a record high of 38,915.87, fueled by years of asset price inflation. The asset bubble burst soon after, leading to decades of economic stagnation. It took 34 years, but on February 22, 2024, the index hit a new all-time high.

Powerful forces turned the tide. A combination of high global inflation, ultra-accommodative BoJ policy, and a weakening yen helped Japan import inflation and emerge from its deflationary spiral. Japan’s core inflation has now stayed above the BoJ’s 2% target for 24 consecutive months. Core inflation is expected to remain above 2% in the near term, reflecting prolonged goods inflation and broadening services inflation amid rising labor costs. Wages are expected to continue rising at the fastest pace in 30 years. That bodes well for higher consumer spending and suggests Japan’s deflationary era has finally come to an end.

A much-improved inflation outlook could in turn support further rate hikes, building a virtuous cycle in assisting the BoJ in its policy normalization. Japan’s nominal GDP has staged a solid comeback in recent years and we expect the reflation momentum to continue.

At the same time, shareholder-friendly corporate governance reforms, mandated by the Tokyo Stock Exchange (TSE), are changing the corporate landscape in Japan. The TSE  reforms are expected to boost return on equity (RoE), and could potentially improve corporate operating margins, asset turnover, and  balance sheet management – all of which would support shareholder returns. Early signs indicate that companies in the Tokyo Stock Price Index (TOPIX) that have disclosed information regarding the TSE’s “Action to Implement Management That Is Conscious of Cost of Capital and Stock Price” are seeing valuations expand relative to the overall market.

All in all, a range of factors – improving nominal GDP growth leading to faster revenue growth, rerating potential driven by corporate governance reforms, improved profit margins, and scope for valuation expansion – support structural exposures to Japanese equity.

To be sure, Japanese stocks are not cheap. The yen, on the other hand, appears to be on sale, recording a 34-year low in March.

Real yield differentials have dragged the yen’s negative carry profile to punitive levels. Any potential strength in the currency could provide an incremental boost to international investors in two ways: further enhancing equity upside and dampening the impact of any potential volatility.

TOPIX and MSCI Japan index valuations have rerated to historical highs. However, Japanese stocks are far from overpriced relative to their developed market peers. At the end of March 2024, the MSCI Japan Index (USD) recorded a forward price-to-earnings (P/E) ratio of 15.9x relative to 18.7x of the MSCI World Index. Importantly, too, the region does not appear to be a crowded trade in hedge funds.

High rates, high yield, low recession risk

In the current high rate environment, the deliberate result of the Fed's tight monetary policy, fixed income offers meaningful opportunity – most notably high yields. Although spreads are relatively tight, the nominal yields are compelling, especially with high yield bonds yielding over 8% in early May.

The low likelihood of a recession makes these yields even more attractive. Corporate health is strong, with coverage ratios on the rise against the backdrop of a healthy economy. Additionally, the potential for short-term interest rates (policy rates?) to move lower could bolster high yield, given that a decrease in rates could lead to bond price appreciation. If short-term rates don’t mover lower any time soon and rates stay high, high yield’s ongoing yield would remain attractive, with bonds pulling to par.

Higher interest rates and an equity market rally driven primarily by multiple expansion in recent months have reduced the equity risk premium. As a result, higher all-in yields when combined with negative correlation between spreads and interest rates, make high yield credit attractive on a risk-adjusted basis.

High yield currently offers the highest yield with the shortest maturity profile. Our strategy involves a calculated overweight in short-term credit alongside a short position in long-term Treasuries, while maintaining a neutral stance on total duration targets. This approach aims to leverage benefits from a potential yield curve steepening (an outcome we believe the Fed is steering toward) and enhance portfolio performance in the prevailing rate landscape. Even in a sticky inflationary scenario, where duration could take a hit, high yield’s spread and carry could help buffer losses and potentially generate positive returns over the near term.

We are therefore constructive on high yield as long as recession risk remains low — which could keep a check on default rates.

Quarterly Re-wind

Here we assess how our forecasts played out over the past quarter.

In last quarter's Multi-Asset Solutions Perspectives, we saw the potential for declining inflation and anticipated more Fed rate cuts than the market had priced in. Instead, the Fed has continued its restrictive rate policy in order to manage still-lingering inflation. As a result, market pricing of Fed rate cuts changed dramatically.

Still, in our view the policy shift does not diminish the underlying economic support for risk assets. The resilience demonstrated by the economy suggests that – Fed policy notwithstanding – the credit sector should remain attractive to investors.

In the real estate space, the past quarter evolved roughly as we anticipated, although a meaningful rise in rates – from 3.9% at the end of 2023 to 4.2% by the close of Q1 – did a little more damage than we expected. Many real estate transactions stalled or foundered. Looking ahead, we anticipate a tougher climate for real estate debt holders if rates remain elevated.

Still, we see signs that real estate values could be nearing their cycle lows. A high profile deal in the space, Blackstone Inc.'s strategic $10 billion acquisition of publicly listed rental housing firm Apartment Income REIT (also known as AIR Communities), signals confidence in the long-term potential of the U.S. property market. Such a significant investment in the high-end apartment sector, especially at a time of tightening financial conditions, reminds us that discerning investors can uncover value in a transitioning market.