Europe has seen a modest pick-up in economic growth in the first quarter, with unexpectedly strong figures coming in from France and Italy. But the region still faces an environment characterized by low interest rates with low expected economic growth and low inflation. This environment resembles the scenario Japan faced in the 1990s. What are the lessons for investors in low-volatility European stocks?
Despite the ‘green shoots’ of higher economic growth, the long-term outlook for growth in Europe remains unfavorable, because the continent is facing a shrinking population, while doubts still linger about the future of the Eurozone. Discussions about the impact of a possible Grexit – and even a Brexit – are clear signs of this.
Given the macroeconomic backdrop of low interest rates it’s perhaps not surprising that investors are aware of a possible return of increased stock market volatility while maintaining a focus on dividends. Since low-volatility stocks have a lower risk and the companies tend to have more stable cash flows, investors might wonder how these stocks perform in an environment of low or very low bond yields.
Pim van Vliet, portfolio manager of European Conservative equities, has looked at a country that has faced similar market circumstances in the past: Japan. Because bond prices around the world have fallen considerably since 2012, his research has become more relevant. His sample period includes the time after the Japanese asset price bubble’s collapse within its economy.
This period is sometimes called ‘the lost decade’ by the Japanese. Together with researcher Simon Lansdorp, he reviewed the data of this country during the period 1986-2011, when the median level of Japanese interest rates was only 1.86%. He split the 26 years of data in two groups of equal size: one with relatively low bond yields, and one where they were relatively high.
In his research on the performance of Japanese stocks, Van Vliet compared the performance of three strategies: a generic low-volatility approach, an enhanced low-volatility approach, and the market-cap weighted index. An enhanced approach, which resembles the Conservative strategy, includes momentum and valuation factors to increase return.
“For Japanese equities, we found that the two low-volatility strategies offer protection against very low equity returns which occur during periods with low bond yields,” says Van Vliet. “Moreover, an enhanced low-volatility strategy generates higher returns than a generic low-volatility strategy, as is also the case during periods of high bond yields.”
‘The Japanese experience is relevant for Europe’
The low-growth and low bond yields environment was unfavorable for Japanese equities: returns for the market capitalization weighted index were negative with -2.3%. Returns for an enhanced low-volatility strategy were +5.6%, considerably higher than a generic low-volatility strategy, which returned +2.3%.
“The strong performance of low-volatility stock during times of low bond yields makes sense,” says Van Vliet. “Let’s consider the main drivers that determine the price of a stock. This price can be seen as the present value of future cash flows in the form of dividends available for shareholders. A low bond yield scenario has a two-fold effect on these drivers, which favors low-volatility stocks.”
“First, a low bond yield translates into a low discount rate, which would push up equity prices. Second, a low yield signals low GDP growth and low inflation, and thus lower growth in future cash flows. Low-volatility stocks tend to have higher dividend yields of 1-2% and lower discount rates of -1% to -2%. This means that the average stock should have up to 4% more structural growth than a low-volatility stock, which in the long run seems not to be the case.”
European Conservative has a dividend yield which is considerably higher than the market. The strategy offers a dividend yield of 4.0% versus 3.2% for the MSCI Europe Index. The Japanese experience is relevant for Europe, argues Van Vliet.
“It is not feasible to fully project the recent Japanese experience because many differences exist between Europe and Japan. Still, historical scenarios could give an indication of how certain strategies will likely perform under similar conditions.” An enhanced low-volatility strategy might be prudent given the current economic environment and the geopolitical political risks, he concludes.
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