JCB RETURNS +2.21% IN Q1, 2017 FOLLOWING ON FROM +2.99% IN 2016 AND +4.94% IN 2015

• THE SWAMP DRAINS TRUMP
• APRA AND RBA ARE WORRIED ABOUT HOUSING AS MORTGAGE RATES CONTINUE TO RISE
• HOW EXPOSED IS YOUR PORTFOLIO TO THE AUSTRALIAN HOUSING AND FINANCIAL SECTOR AS TAIL WINDS TURN TO HEADWINDS?
• THE FED WILL CONTINUE TO HIKE US INTEREST RATES, LIFTING THE GLOBAL COST OF CAPITAL, THE PRECURSOR TO RECESSIONS.
• JCB SECULAR THEME – GLOBAL INTEREST RATE CONSOLIDATION AFTER LONG TREND WITH RBA ON HOLD AT 1.50% FOR 2017

The Swamp drains Trump

Jamieson Coote Bonds (JCB) have written on a host of topics since the election of President Trump in Q4 2016, many of which disagreed with mainstream media opinion. We argued Trump would struggle to swiftly deal with Washington and that his agenda would likely be watered down and delayed.  As we close the first quarter of 2017, it is the swamp that is draining President Trump.

Healthcare is dead in the water; the Republicans are divided whilst the budget is in gridlock as we approach the US debt ceiling. Tax reform and financial deregulation remain on the agenda as the great hope for the risk market bulls, but given the total failings in healthcare reform they must be getting nervous. Add increasing geo-political tensions and 2017 is shaping up as being a challenging year to navigate for investors.

APRA and RBA are worried about housing as mortgage rates will continue to rise

Trump and his higher growth agenda have a host of implications for Australian investors. We have already seen out of cycle mortgage hikes from Australian banks before Christmas last year and again this year in response to higher funding costs from the US Federal Reserve (the Fed). Australian banks still source a significant amount of their internal funding from US markets where the cost to borrow funds will increase with every US Fed hike, and this increased cost will be passed through to Australian mortgage rates.

APRA and the RBA have increased public comment on the pending risk to the Australian economy from the highly-leveraged property sector as mortgage rates have moved higher over the last few months. Debt to income levels continue to push higher whilst wages growth remains at the weakest levels on record. Australian households have never been as interest rate sensitive. A historically slight rise in mortgage rates by 200 bps would add 50% to the cost of servicing a 4.00% loan. Assuming interest only mortgage payments of $1000 a week, this would result in loan servicing jumping to $1500 a week. With the weakest wages growth on record that would generate significant stress to mortgage servicing, with flow on implications for banks and the broader Australian economy. Add to that Labour’s commitment to curtail negative gearing and all the elements are present for a significant change in the wind. As market forces led from the US dominate the cost of global capital, JCB believe that the RBA will remain dormant in 2017.

How exposed is your portfolio to the Australian housing and financial sector as tail winds turn to headwinds?  -

Australian property buyers have enjoyed twin tail winds of declining interest rates and easy availability of credit for a significant period. Given the changing backdrop of debt servicing costs (via the Fed rate hikes passed on as out of cycle rate hikes) and in tightening of credit supply (via APRA macro prudential mortgage criteria) it is again prudent to consider portfolio exposures to the financial system. Term deposits, corporate bonds (mainly financial in Australia), hybrids, negatively geared property and bank shares are all financial sector exposures. Whilst we applaud portfolio diversification, we urge investors to consider the tightly correlated risks associated with investing in highly aligned exposures, particularly as long term trends are changing.

The Fed will continue to hike US interest rates, lifting the global cost of capital, a precursor to recessions in other cycles -

The US Federal Reserve have used the window of Trump inspired optimism and robust equity valuations to bring forward planned 2017 rate hikes, delivering a March 2017 hike in the first back to back interest rate hikes in more than a decade. The current market expectation remains for 3 rate hikes over 2017, all of which have been reflected in current market pricing. JCB continues to expect a further rate hike in June followed by an additional hike in H2 2017 taking the upper bound for US interest rates to 1.50%, matching that of the RBA.

When the Fed are hiking, they are trying to slow down the economy by making the cost of funding capital more expensive. This usually requires more than one adjustment, and each rate hike comes with a significant lag to the real economy. The more the Fed hike funding interest rates, the more they are ''tightening'' financial conditions in the economy through the funding (cost of capital) mechanism. Whilst funding rates are higher for borrowers (making loan servicing more expensive), rates are also higher for lenders, and thus international capital flows from other currencies into USD to benefit from higher interest rates received as a lender. This usually pushes the USD currency higher, further tightening financial conditions as imports become more expensive and exports are less competitive.

With the Fed intent on continuing this tightening cycle, JCB expect short dated fixed income products to revalue to higher yields. However, as we pointed out in our February monthly, once the Fed actually start hiking interest rates longer dated bonds tend to perform quite well. This is because they enjoy a relief rally given that inflation expectations are being met by an active Fed and because they also price in the increased probability of a financial accident in a tighter monetary environment. If you had bought US 10 year Government Bonds a week before the hiking cycle of 2004-2006, despite the Fed hiking 425 bps (rates being lifted by 4.25%), you would have enjoyed a total return of 6.50% over that rate hiking period. US 10 year government bond yields have rallied significantly since the Fed hiked in March this year, leading Australian 10 year bonds to higher prices.

JCB Secular Theme – global interest rate consolidation after long trend with RBA on hold at 1.50% for 2017 -

Despite all the recent media attention on bonds, we noted this month that since starting the JCB Active Fund in 2014, Australian 10 year bond yields have not really moved. The closing yield for bonds at year end 2014, 2015 and 2016 has been very close to 2.80% (actual yields have been 2.74%, 2.88% and 2.76%) As at the end of Q1 2017, Australian 10 year Bonds yielded 2.70%. Our broad secular theme remains that bond yields will remain in a consolidated range during a benign period for the RBA who remain very unlikely to raise or cut interest rates in the near term.  This will offer up significant opportunity for alpha generation for active managers.

Chris Manuell and Paul Chin join the JCB team, alpha generation continues to grow with improved investment process  -

JCB has expanded the investment team with the addition of Chris Manuell (previously worked with Charlie Jamieson at BAML London), joining Paul Chin who joined the firm in 2016. Chris brings 23 years’ experience (16 years offshore) and is a holder of the converted Chartered Market Technician (CMT) nominal – one of the few in Australia to hold this prestigious US based designation. Chris joins Paul Chin who brings 21 years’ experience as a portfolio manager and investment research and strategist (with 7 years offshore working for Blackrock (BGI) San Francisco).

The JCB investment team is now complete with 4 senior employees with a collective 80 years’ experience in fixed income markets, 42 years of which was generated offshore.

JCB is moving offices  -

JCB will be relocating up 3 floors to Level 30, 101 Collins Street, Melbourne as of the end of April. In the interim our contact details will remain the same although our telephone numbers will be updated in coming months. JCB looks forward to welcoming you to our newly designed customised offices, execution dealing floor and boardrooms in the coming months.

FUND UPDATE FOR MARCH

JCB returns +2.21% in Q1, 2017 following on from +2.99% in 2016 and +4.94% in 2015.

In March 2017, the JCB active fund returned 0.91% (gross), outperforming its benchmark by 0.425%. The fund benefited from increasing duration exposures into the US Fed rate hike in the middle of the month which we had previously identified as an opportunity to add duration given the market concessions on offer. The fund also benefited from performance of some short dated supra national bonds which tightened on spread as international buyers continue to have elevated demand for high quality AAA securities. The fund remains under weight duration in keeping with its lower beta exposures, however, we continue to look for tactical opportunities to drive additional alpha opportunities and performance whilst at all times protecting capital.