GF Securities' Dai Kang: How does the Japanese debt cycle framework guide asset allocation?

Introduction: Japanese Experience: How to Manage Asset Allocation During a Period of Debt Recession In our 24.7 report, we highlight the use of two key indicators - "Debt-to-GDP ratio" and "Total debt-to-GDP ratio" to clearly identify the different stages of Japan's long debt cycle in the 1990s. 1. Expansion stage of the debt cycle - Early debt cycle, bubble, peak (actively leveraged stage): Debt-to-GDP ratio increases, Total debt-to-GDP ratio increases. In the late 1980s, the Bank of Japan continuously lowered interest rates, leading to a "credit boom" and the private sector significantly increasing its leverage, resulting in both the Debt-to-GDP ratio and Total debt-to-GDP ratio rising simultaneously, leading to an asset bubble. 2. Contraction stage of the debt cycle - (passively leveraged stage): Debt-to-GDP ratio decreases, Total debt-to-GDP ratio increases. In 1989, Japan's monetary and credit environment tightened, causing the asset bubble to burst, leading to a self-reinforcing economic contraction. In the 1990s, in order to reduce debt burdens, the private sector in Japan voluntarily slowed down its credit expenditure, but with a faster decline in GDP growth rate along with the objective existence of taking on new debt to pay interest - leading to "passive leverage" (Total debt-to-GDP ratio continues to rise), Japan did not effectively achieve "deleveraging" in the 1990s. Harmoniously deleverage, gradually moving towards normalization (deleveraging stage): Debt-to-GDP ratio decreases, Total debt-to-GDP ratio decreases. As we previously pointed out in the 24.2 "Comparison and Outlook of Japan in the Debt Cycle Perspective", after the debt crisis, due to Japan's large-scale fiscal/monetary easing policies starting relatively late, the government's lag in dealing with bad debts compounded by demographic issues, Japan's debt resolution process has been very slow, with long-term economic stagnation and deleveraging process being exceptionally difficult. It was only after 2000 that Japan's residents started to decrease their total debt-to-GDP ratio. After the introduction of Abenomics in 2012, Japan's economy significantly improved, with more deleveraging being achieved through economic growth, transitioning from painful deleveraging to harmonious deleveraging stage, and the debt cycle gradually moving towards normalization stage. How does the debt cycle framework guide asset allocation in the Japanese stock and bond market? (1) Strategic level: During a period of debt recession, growth factors are the core contradiction, fixed income assets outperform equities, and there should be a strategic overweight. Since the 1990s, Japan has entered a long period of debt contraction (including passive leveraging, accelerated deleveraging, and decelerating deleveraging), and the correlation between Japanese stocks and bonds remains negative - reflecting that growth factors are the core contradiction affecting asset allocation in Japan during a debt recession. During a debt contraction period, the Japanese government bond market tends to trend upwards (with a high success rate). In particular, during the passive leveraging phase, under continuous interest rate cuts, bond yields decline most significantly ("steep bull market"); as Japan enters the accelerated deleveraging and decelerating deleveraging phase, as short and long-term interest rates have reached sufficiently low levels, the characteristics of the "steep bull market" may gradually diminish, but the downward trend in interest rates is likely to continue, making government bonds still have long-term allocation value; (2) Tactical level: During a period of debt recession, seize the opportunity for equities during the "credit pulse". In the long period of debt contraction in Japan, there are often short periods of economic improvement triggered by the "credit pulse", with the conditions being more related to a sufficiently loose monetary policy stage that temporarily relieves the private sector's debt burden: Nominal GDP growth rate (g) minus policy interest rate (r) and Japan's comprehensive economic index show a strong positive correlation. In small upturn cycles, equity asset growth is often driven by growth factors, seizing the opportunity for equities during the "credit pulse". How does the debt cycle framework guide Japanese stock market investments? Japanese stock market experience: Strategic level debt cycle framework & tactical level economic cycle framework can effectively guide stock market style factor timing - (1) Strategic level: The debt cycle framework effectively guides (value, dividend, growth factors), based on understanding the position of the long debt cycle (over 10 years) -> strategically increase/decrease exposure to (value, dividend, growth factors). During a debt contraction period, increase exposure to (high dividend & high value factors), decrease exposure to (high growth factors); while during a debt expansion period, increase exposure to (high growth & high dividend factors); (2) Tactical level: The economic cycle framework effectively guides (volatility, quality, liquidity factors), based on understanding the position of the economic upturn cycle (1-3 years) -> tactically increase/decrease exposure to (volatility, quality, liquidity factors). During an economic upturn cycle, increase exposure to (high liquidity factors), decrease exposure to (low volatility & high quality factors); during an economic downturn cycle, increase exposure to (low volatility & high quality factors), decrease exposure to (high liquidity factors). How does the debt cycle framework guide Japanese stock and bond asset allocation? (1) Strategic Level: During a period of debt recession, growth factors are the core contradiction, and fixed income outperforms equities 1. Japanese Experience: During a period of debt recession, "growth factors" are the main contradiction that guides the allocation of Japanese stocks and bonds. Bridgewater highlighted in their 2009 report "The All-Weather Strategy" that inflation and growth are the two most crucial macro factors influencing asset prices. When inflation is the core contradiction, both equities and bonds benefit from expectations of loose liquidity due to falling inflation, leading to a positive correlation in stock and bond yields. However, when growth is the core contradiction, improving growth expectations boost earnings for equities while causing bonds to suffer, resulting in a negative correlation in stock and bond yields. Growth and inflation are the two most important determinants of asset class pricing (both because of their direct impact and the fact that they encompass expectations about most other relevant facStocks and nominal bonds are positively correlated when changes in inflation expectations are driving markets, as both asset classes benefit from a decrease in inflation. They are negatively correlated when changes in growth expectations drive market returns, as declining growth benefits nominal bonds but harms stocks (and vice versa).Since the 1990s, Japan has entered a long period of debt deleveraging (including passive leverage, accelerated deleveraging, and decelerated deleveraging), and the correlation between stocks and bonds in Japan has remained negative -- reflecting that growth factors are the core contradiction affecting the allocation of Japan's assets. How to understand this? The trend of stock-bond yield correlation turning negative indicates that the structural fixation of growth factors is the core contradiction affecting Japan's asset allocation. This usually happens during a period of debt deleveraging, when monetary policy tends to remain loose to support economic development, making growth factors more dominant in asset allocation. Japan's Experience: During a period of debt deleveraging, strategically, fixed income assets have outperformed equity assets. For the Japanese bond market, Japanese interest rate bonds have shown a long bull trend (high success rate), leading to a strategic overweight of interest rate bonds. In the passive leverage phase, under a continued cycle of interest rate cuts, bond returns decline most significantly ("bull steepening"). As Japan enters the accelerated deleveraging and decelerated deleveraging phases, as interest rates have reached sufficiently low levels on both the long and short ends, the "bull steepening" characteristic may gradually fade, but the downward trend in interest rates is likely to continue, making interest rate bonds still a viable long-term investment! During a period of debt deleveraging, for the Japanese equity market, the success rate of equity markets is overall lower than that of fixed income assets in the passive leverage and accelerated deleveraging phases, until the decelerated deleveraging phase where the success rate of equity markets significantly increases. (Two) Tactical level: During a period of debt deleveraging, seize the opportunity to invest in equity assets under the "credit impulse" Reviewing Japan's experience: Nominal GDP year-on-year-policy rate is a leading indicator of business trends. Bond relies on a combination of large-scale fiscal and monetary policies, but during Japan's long period of debt deleveraging, there have been credit impulse cycles of improved economic conditions, triggered by sufficiently loose monetary policies to some extent relieving the private sector's debt burden: Nominal GDP year-on-year (g) - policy interest rate (r) and the Japanese economic comprehensive index show a strong positive correlation. Reviewing Japan's experience: During small business cycles within a period of debt deleveraging, equity asset increases are often driven by growth factors. Overall, at the tactical level, during a period of debt deleveraging, one should seize the opportunity to invest in equity assets under the "credit impulse". Three, how does the debt cycle framework guide investments in the Japanese stock market? Japanese stock market experience: Both the strategic level of the debt cycle framework and the tactical level of the business cycle framework can effectively guide stock style factors timing-- Strategically: The debt cycle framework effectively guides (value, dividend, growth factors) according to the position in the long debt cycle (10 years or more) --> strategically increase/decrease exposure to (value, dividend, growth factors) -- increase exposure to high dividend & high value factors, decrease exposure to high growth factors during the debt deleveraging period; whereas increase exposure to high growth & high dividend factors during the debt expansion period; Tactically: The business cycle framework effectively guides (volatility, quality, liquidity factors) according to the position in the economic cycle (1-3 years) -- tactically increase/decrease exposure to (volatility, quality, liquidity factors). (One) Strategic level: The debt cycle framework effectively guides (value, dividend, growth factors) Japanese review experience: Strategically, the debt cycle framework effectively guides (value, dividend, growth factors) Through back-testing data in three dimensions, it can be verified that the debt cycle framework effectively guides (value, dividend, growth factors) -- increasing exposure to high dividend & high value factors, decreasing exposure to high growth factors during a period of debt deleveraging; whereas increasing exposure to high growth & high dividend factors during a period of debt expansion; in addition, during the acceleration of deleveraging (pre-deleveraging) --> deceleration of deleveraging (post-deleveraging): TPX dividend, value factors have always been leading, but growth factor performance continues to improve. Dimension one: Back-test results of each single-factor Q1 group of (long) Tokyo TPX index: High growth factors are very sensitive to the debt cycle, moving from the debt expansion period to the debt deleveraging period, TPX high growth factors lead to decline; High value factors are also sensitive to the debt cycle, moving from the debt expansion period to the debt deleveraging period, TPX high value factors lead to rise; High dividend factors consistently lead, regardless of whether it is the debt expansion or deleveraging period; Note: High value (Q1), high dividend yield (Q1), high growth (Q1), high low volatility (Q1), high quality (Q1), high liquidity (Q1), high momentum (Q1), high market value (Q1) are constructed based on the top 20% of TPX component stock selection for each factor combination, with monthly rebalancing Dimension two: Back-test results of each single-factor combination of (long-short) Tokyo TPX index; Note: (Long-short) value, dividend yield, growth, low volatility, quality, liquidity represent constructing combinations based on the top 20% components of each factor for long positions and the bottom 20% of each factor for short positions, with monthly rebalancing Dimension three: Back-test results of each single-factor Q1 combination of the US market and MSCI emerging markets: In 2008, the US experienced a subprime mortgage crisis, entering a period of debt deleveraging, while compared to this, emerging market debt cycles were in a healthier position, with the transmission of the subprime crisis causing more of a one-time impact, and under policy stimuli, emerging market economies recovered ahead of the US. With the debt cycle phase mismatched, high growth factors in the US and emerging markets significantly differentiated, further validating that during a period of debt deleveraging, exposure to high growth factors should be reduced. (Two) Tactical level: The business cycle framework guides (volatility, quality, liquidity factors) Japanese review experience: At the tactical level, the business cycle framework effectively guides the investment strategy of stock style factors through back-testing data in two dimensions: business cycle upturn period increases exposure to high liquidity factors, decreases exposure to low volatility & high quality factors; business cycle downturn period increases exposure to low volatility & high quality factors, decreases exposure to high liquidity factors.Do not conduct backtesting on the performance of various single-factor Q1 combinations of the TPX index: the low volatility factor is sensitive to the business cycle, transitioning from the upturn to the downturn, the TPX high and low volatility factors go from trailing to leading; the high-quality factor is sensitive to the business cycle, transitioning from the upturn to the downturn, the TPX high-quality factor goes from trailing to leading; the high volatility factor is sensitive to the business cycle, transitioning from the upturn to the downturn, the TPX high and low volatility factors go from leading to trailing; Note: high and low volatility (Q1), high quality (Q1), high liquidity (Q1), high momentum (Q1), high market value (Q1) respectively construct combinations based on the top 20% of TPX component stocks selected for each factor, with monthly rebalancing.Dimension 2: Backtesting results of long-short strategies for different single-factor Q1 combinations of the TPX index: Note: (long-short) low volatility, quality, and liquidity are constructed by taking long positions in the top 20% of factors and short positions in the bottom 20% of factors among TPX component stocks, with monthly rebalancing. Risk Warning Overseas experience is not equivalent to domestic experience, historical experience is not suitable for linear extrapolation, domestic economic growth is lower than expected (exports dragged down by overseas demand, real estate consumption confidence difficult to recover, "steady growth" policy measures lower than expected, etc.), geopolitical conflicts exceed expectations (Russia-Ukraine conflict continues to disrupt energy supply), etc. This article is reposted from the WeChat official account "Dai Kang's Strategic World"; Authors: Dai Kang, Li Xuewei, Yang Teng; GMTEight editor: Wang Qiujia.