CHINA DEVALUES YUAN AS DATA COLLAPSES, EQUITIES BEARISH DEATH CROSS, FOMC BLINKING, AUSSIE CAPEX SHOCKER (AGAIN)

Bonds are boring. So boring. Imagine how dull you’d be if you talked about bonds all day? I often wonder, as I stand alone at cocktail parties, why everyone loves real estate agents? Is it because they tell you what you want to hear? Sorry to tell you but unfortunately, August was all bad news and it looks like we have plenty more to come. August had been fairly uneventful until China dropped a financial nuclear weapon in response to horrific export trade data at -8.3% year on year with a shock devaluation of its currency against the USD on August 11th. This is HUGELY important for markets. China is now exporting deflation around the region by artificially making itself more competitive via a lower currency. Weakness in China was further confirmed with bad manufacturing data on Friday the 21st leading to the worst 4 day fall in the US equity markets in 75 years (in point terms). After a Chinese RRR rate cut in response to collapsing equity markets, US equity markets had their biggest 2 day gain. This is not usual volatility, it is a symptom of markets that have been too manipulated for too long. Most investors can handle a pull back, but losing a year or more of gains in a few trading sessions should be a large wake up call for complacent portfolios who should revisit portfolio construction and allocations across asset classes. China has poured huge amounts of liquidity and effort into stabilising their equity markets which has not worked. Are they losing control? Bonds are boring until everything else is dangerous (see attached chart vs equities). In August alone, Australian equities have lost 8.6% whilst bonds have continued to grind forward. Trend is your friend in markets and US equities are now trending lower on a long term basis.

Fears over weakening global trade, potential rate hikes from the FOMC and collapsing commodity prices have seen equities trading lower since May. They have now generated a technical ‘’death cross’’ where 50 day moving averages close lower than the 200 day moving average price, illustrating long term trend reversal. Investors should remain very cautious going forward as weak price action continues with equity rallies now being used as selling opportunities. We expect bonds to continue to perform as investors search for high quality, low risk and low volatility fixed income assets.

The new catchphrase in equity markets is ‘’I’m a long term investor’’, which has followed on from ‘’equities with bond like characteristics’’ earlier in the year. Which equites had those bond like characteristics? Woolworths, a place we shop every week, down 10% in a day. Banks down over 20% from their highs. Good stable businesses being violently repriced. Looking forward we have move to worry about.

Yield premiums ( credit spreads) on investment-grade debt have widened by 32 basis points over the past three months, according to Bank of America Merrill Lynch index data. Since 1996, there have been five occasions when credit spreads showed similar movement. Two of them preceded recessions in 2001 and 2007 when stocks went on to drop 50 percent or more. In the other three instances, the S&P 500 fell at least 16 percent while the economy continued to grow. The latest was in August 2011, when the S&P 500 was mired in a 19 percent retreat that almost ended the bull market. Assuming the U.S. economy will be able to avoid a recession this year, as predicted by economists surveyed by Bloomberg, and stocks fall by the average magnitude to reflect similar credit stress in the past, the S&P 500 would hit 1,742, a 18 percent decline from its all-time high reached in May. That level, last seen in February 2014, represents a 12 percent drop from its August close. http://www.bloomberg.com/news/articles/2015-08-31/s-p-500-rout-has-room-to-go-if-bond-spreads-have-anything-to-say

JCB has argued for some time that the FOMC shouldn’t raise rates in 2015 as the data and market construct does not allow. We wrote at length about this last month and how economists have consistently called this incorrectly. If they do hike, JCB believes it will be less than the 25 bps expected by markets (Yellen has a history of soothing market risk transfer) so we assume 12.5 or 15 bps hike if they go but ultimately, even a small move will be viewed as a policy error (same as ECB hike in 2011) as it will contribute to a deeper equity market sell off on USD strength. We still assume no move but there is a small probability they will move.

Australian data over August remained on weaker side with unemployment climbing to 6.3% and Q3 capex data again coming in weak at -4%. Whilst a lower currency is helpful in rebalancing Australia’s economy, we still face significant head hinds from lower commodity prices as evidenced by our declining terms of trade. Without any fiscal stimulus forthcoming, the RBA will ultimately continue its cutting cycle, despite what it says in public. Don’t forget the RBA wished everyone a Merry Christmas with language ‘’a period of stability is warranted’’ with reference to rates and cut immediately in February without warning. They are a 100% reactionary Central Bank which is why we maintain our long held view that they will cut again in November ’15 after Q3 inflation report.

There is an old maritime brokers saying ‘’dictum meum pactum’’ meaning ‘’my word is my bond.’’ It is boring no doubt, but sometimes you should just take the bonds and leave the words and promises to others.

FUND HIGHLIGHTS & POSITIONING

JAMIESON COOTE BONDS ACTIVE FUND GAINED 0.56% GROSS DURING AUGUST. AFTER THE RALLY IN BONDS MARKETS IN JULY, JCBAF LIGHTENED DURATION INTO MONTH END AND ADDED TO CURVE FLATTENING EXPOSURE IN SYMPATHY WITH DECLINING OIL PRICES.

We also added some semi (state) government exposure up to 35% of portfolio to capture additional carry through the usually quiet August period. After the surprise Chinese devaluation of the Yuan we added duration and cut additional semi risk, moving back into core ACGB holdings. We initially outperformed the market in early part of the month, however the shock Chinese announcement generated a snap steepening of the curve, catching us poorly positioned, and we gave up that initial outperformance. The fund finishing the month essentially at index returns, 3 bps ahead of index gross or 3 bps below the index net of all fees. We expect significant financial market volatility going forward into Q4, hence we will run lighter risk and look to capture those opportunities as they arise rather than sitting on a large core position. We broadly expect bonds to continue to do well and risk markets to be vulnerable, but we need to watch for significant policy response from authorities which may dampen flight to quality premiums.