RBA PAUSES FOR NOW WHILST CORPORATES WOBBLE

Following the RBA rate cut in February and decline in commodity markets over the month of March, markets continue to expect rate cuts from the RBA in coming month with the interest rate swap market pricing for a year end terminal rate around 1.60%! JCB maintains its long held view that the RBA will cut the cash rate in May to 2.00% (after seeing April 22nd Q1 CPI inflation data) with further cuts to come later in the year.

The collapse in commodity markets (iron ore off 21% since Feb cut from $62 to $47), is causing significant issues for parts of the corporate sector and has far reaching implications for the economy and the federal budget. Fortescue Metals Group failed to refinance $2.5 billion in debt with a failed bond sale in mid-March (iron ore at $55 a tonne at the time, now at $47). Initially the company attempted to secure a syndicated bank loan, but once it was clear the company has lost the faith of its bankers, it turned to the high yield bond market in the United States. The heavily indebted miner could not secure funding at commercial rates and was forced to pull the offering altogether. Fortescue has nearly $12 billion of debt falling due in coming years. Once funding markets seize on a corporate they rarely reopen without a major restructuring. The playbook from here is ugly and often looks something like the following…. Hedge funds short sell the stock and plant a host of negative news articles in the media, ratings agencies get nervous and issue debt downgrades, further closing the funding market door. Once it is clear that a solvency issue is approaching a major restructuring, capital raising or trade sale must ensue. It is a shocking cycle that we have witnessed firsthand during the GFC working for US banks. Corporate failures will rise over the year, as mining boom turns to mining bust for indebted companies with weak cash flows and growing solvency issues.

The rapid and sustained fall in commodity markets coupled with contractionary fiscal policy, ensures the RBA will continue cutting to support currency and interest rates sensitive parts of the economy and sure up sagging confidence. There are risks associated with further rates cuts, predominantly in bubble like property markets of Sydney and Melbourne, however this is seemingly the lesser of two evils in a tricky balancing act for the RBA. This ultimately requires APRA to provide macro prudential policy restrictions, capping loan to valuation ratios in some investment markets.

Turning to offshore markets March’s mid-month meeting of the US Federal Reserve saw a marked shift in FED speak from Chair Janet Yellon who lowered the ‘’dot plot’’ or the FED’s expected glide path for US interest rates whilst also removing the key phrase ‘’patient’’ from the statement. This effectively ends the post GFC policy of forward guidance from the FED – which in turn will lift volatility of all financial markets. Data in US has been declining of late. JCB believes the FOMC will raise rates in Sept 2015, however we believe it will be a very small increment of 10 bps rather than market consensus at 25 bps.

European Quantitative Easing continues in full swing with 10 year German Government debt now yielding a whopping 16bps or 0.16%. If that doesn’t encourage an investment then maybe you should consider 2yr German Government Debt at -28bps or -0.28%. We live in truly amazing times. Australian Government Debt, AAA rated, Westminster system, slowing economy, fiscal contraction, RBA with cutting bias, continues to attract massive foreign buyers and will do so for some time yet. JCB remains very constructive on Australian Government Bonds.

FUND HIGHLIGHTS & POSITIONING

JAMIESON COOTE BONDS ENJOYED RETURNS THROUGHOUT MARCH OF 0.89% MAINTAINING OUR MOVE TOWARDS OUR HIGH SINGLE DIGIT RETURNS ON A PER ANNUM BASIS.

Over the course of March the largest risk for the portfolio was mid-month FOMC meeting where we reduced duration significantly surrounding the event risk, in keeping with our risk management philosophy. Chair Yellon removed the word ‘’patience’’ but lowered the dot plot catching markets offside, which caused a significant rally in Global Bond markets. JCBAF added duration immediately as the desk was staffed for FOMC meeting.

The ongoing deterioration of commodity complex will continue to support the Australian Government Bond market although may create some widening pressure on State Government paper. The budgetary positions of both West Australia and Queensland State Governments require careful consideration as falling mining based revenues will impact budgets positions and therefore pricing for State issued bonds. Any further performance will be an opportunity to lighten all state holdings and return to Federal Government holdings.