JCB RETURNS +4.10% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• RE AFFIRMING OUR SECULAR VIEWS AROUND INFLATION
• UTILITIES PRICES CREATE ONGOING INCOME SHOCK BUT NOT INFLATION
• MORTGAGE STRESS SOARS AROUND THE COUNTRY – MORE TO COME
• GET READY FOR MORE OUT OF CYCLE RATE HIKES FOR XMAS
• LARGE RALLY IN BOND MARKETS AS 2018 RBA HIKES CHALLENGED
• PORTFOLIO PERFORMANCE – ON TRACK TO DELIVER 3 TIMES RBA CASH RATE

Re affirming our secular views around inflation

Recent market discussion has turned towards the possibility of increased inflation as most western economies are at full employment (although sadly not Australia). Jamieson Coote Bonds has long held the secular view that some inflation will emerge at times, however, material inflation cannot be sustained. In a heavily indebted world, if central banks remain true to mandates and hike interest rates on a lift in inflation readings the likely result will be an income shock to the indebted, which has deflationary consequence (as seen in Canada this year). It is very important to acknowledge that inflation coming from an ultra-low levels up to just a low level is ‘’inflationary’’ with positive data velocity. However, this should not be confused with secular inflation of the 1970’s era, as many of the drivers of our current secular deflation remain. These are declining western demographics, high debt burdens (makes escape velocity difficult), robotics and automation, technology, immigration and the decline in worker unionisation.

With markets very focused on possible inflation velocity, we thought it prudent to deep dive over and above our usual periodic examination of JCB’s secular views with the Advisory Board re-examining the sustainability of positive inflation velocity if it should materialise. After vigorous debate around this topic, the Advisory Board remains generally comfortable that whilst some velocity is to be expected, it remains unlikely that it would be sustained in an economy which experienced higher funding interest rates. This is because any higher wage inflation is quickly cancelled out via income shock due to higher funding costs of servicing debt after rate hikes.

Utilities prices create ongoing income shock but not inflation

Australian consumer price inflation data failed to materialise with any velocity over the 3rd quarter, printing at 1.8% YoY, well below the RBA mandated level of 2-3%. This was despite significant rises in electricity prices at +8.9% and a further rise in tobacco at +4.1%. Inflation has now been below the official RBA target range for all but one of the last twelve quarters – showing how persistent and secular the undershoot remains – even in spite of significant utilities price pressure.

Mortgage stress soars around the country – more to come

Australian mortgage rates will likely move higher into 2018, because the cost of bank funding will almost certainly rise as the global cost of capital is lifted by the US Federal Reserve (the Fed). The Fed is widely expected to raise US interest rates in early December and follow on with further hikes into early 2018. In their October press conference, the Fed confirmed they will run down their balance sheet in an automated fashion and not respond to incoming economic data by changing the size of balance sheet run off. This is crucial because it means the only policy tool available to respond to strong economic data is further rate hikes.

Get ready for more out of cycle rate hikes for Christmas

JCB has written extensively about why US Fed rate hikes ultimately places significant stress on Australian consumers, who have gorged on private debt as interest rates have fallen. Mortgage stress continues to build around the country with Brendan Coates from the highly regarded Grattan Institute recently being quoted in the AFR: “Even a relatively small rise in the interest rates paid by households would crimp their spending. If interest rates increase by 200 basis points, mortgage payments on a new home will be less affordable than at any time in living memory.’’

Despite mortgage stress already gaining steam around the nation, JCB expect Australian Banks to raise mortgage rates in response to higher loan book funding costs – in exactly the same way they hiked ‘out of cycle’ late last year and early in 2017 after the Fed raise rates in the US. This is a tax on consumers who have accumulated record household debt burdens and will be faced with higher funding costs from servicing their loan repayments.

Large rally in bond markets as 2018 RBA hikes challenged

With almost two rates hikes from the RBA priced into bond markets in early October and the likely prospect that consumers will face higher mortgage costs into 2018, it is little wonder that Australian bonds rallied significantly over the month. JCB contacted a number of clients and made the argument that with short dated bonds at their cheapest levels vs RBA cash in 7 years, valuations looked compelling to add exposures as a large fire break of valuation had been established. The RBA continue to re iterate they remain happy with current policy settings and with bond yields at the cheapest levels vs RBA cash in almost 7 years the market bounced significantly over the month, despite US yields finished slightly higher over the month.

Portfolio performance – on track to deliver 3 times the RBA cash rate with high liquidity

JCB portfolios performed well over October generating strong absolute returns taking performance of our master strategy north of 4.50% annualised for the year (if additional bond income due to year end is included). JCB portfolios did underperform the rally of the government index, as we held large exposures in the short dated bonds where we viewed the risk/reward as most compelling to own duration on an outright basis. JCB viewed this as prudent risk management as the market risks over the month were quite pronounced. The appointment of a new US Fed Chairperson, combined with ECB meeting, announcement of US tax reform and Australian CPI data all had potential to pressure longer dated bonds valuations.  All of these market risk events passed without incident in the end and the markets enjoyed a relief rally.  JCB continues to hold our current exposures in the belief that the RBA will find it extremely difficult to hike interest rates in 2018, as headline inflation will fall in Q4of 2017 due to CPI basket being reweighted by the ABS. Combined with out of cycle rate hikes which we expect from the banking system, financial conditions will likely  tighten in Australia over 2018 without any need for RBA participation.

Given the markets are still priced for RBA rate hikes, we continue to view current valuations as generous at a time when Australian consumers are struggling (as viewed by weak retail sales data), burdened by the high cost of non-discretionary items in housing, education, health and utilities.