JCB RETURNS +3.09% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• MARKET PRICES NEARLY TWO RATE HIKES FOR RBA IN 2018 DESPITE CONTINUED REBUTTAL FROM RBA SPEECHES
• LARGE FIREBREAK NOW ESTABLISHED IN CURRENT PRICING, TO REMAIN UNDERWEIGHT FIXED RATE DEBT IS TO EXPECT A 3RD RBA HIKE WHICH SEEMS HIGHLY UNLIKELY EVEN UNDER THE MOST OPTIMISTIC SCENARIOS
• TAX REFORM: TRUMPS LEGISLATIVE PROGRESS TO DATE IS ESSENTIALLY ZERO. ANY ACTUAL TAX REFORM SHOULD BE SEVERELY REDUCED VS ANNOUNCEMENT IF IMPLEMENTED
• CAREFUL WHAT YOU ‘’WARSH’’ FOR – FAVORED US FEDERAL RESERVE CHAIRPERSON KEVIN WARSH LOOKS TO BREAK RECENT RELATIONSHIPS WITH EQUITY MARKETS
• TOYS R US BOND HOLDERS LOSE 80% OF CAPITAL – BONDS FROM 97 CENTS TO 18 CENTS ON THE DOLLAR - A STARK REMINDER ABOUT RISK AS CREDIT HITS CYCLE HIGHS/TIGHTS

Market prices nearly two rate hikes for RBA in 2018 despite continued rebuttal from RBA speeches

Despite continued pushback in speeches from a number of senior RBA officials, markets have moved to price in almost 2 rate hikes for the RBA in 2018. RBA governor Lowe has been explicit regarding rate policy in recent speeches stating that the RBA will not follow other central banks into a tightening cycle whilst the domestic economy continues to have employment slack of 0.6% and below mandate inflation. Positive employment data combined with renewed expectations of an additional US Federal Reserve hike for year-end plus recent rate hikes in Canada have resulted in a cautious mood for bond markets who have moved to add optionality for RBA policy outlook in 2018.

Large firebreak now established in current pricing, to remain underweight short dated fixed rate debt is to expect a 3rd RBA hike which seems highly unlikely even under the most optimistic scenarios

In contrast to the predications of dire bond market returns as rates rise from many vested interested parties, the addition of nearly 2 RBA rate hikes into current market pricing has been entirely orderly, with the product continuing to generate solid returns in excess of RBA cash year to date. Importantly, as the market has already added the optionality of possible RBA hikes into current pricing, a large firebreak has been established for shorter dated fixed rate bonds (active managers don’t always own long dated debt) Should the RBA complete on rate hikes in 2018 this is already reflected in the price of those bonds today, much like a particular stock having been discounted for some possible or expected future event. However, if the RBA fail to raise rates then bonds are historically cheap versus the RBA cash rate and should generate strong excess returns to RBA cash. For those expecting a further pullback in yields the market would then be pricing in the optionality of a 3rd RBA rate hike. Such a scenario looks hugely optimistic versus RBA commentary that continues to remain comfortable with current monetary policy settings and acknowledges the balanced risk outlooks for the Australian economy with highly indebted consumers who are facing significant prices rises in non-discretionary utilities. The RBA Ian Harper made public comment early in October that the RBA are NOT ruling out an additional rate cut. Given nearly two hikes are priced in and the RBA are still discussing rate cuts, valuations look compelling at current levels unless you believe the RBA could hike a 3 times.

With CNN’s fear and greed index having reached an extreme greed readings of 95 out of 100 – massive risk on - (http://money.cnn.com/data/fear-and-greed) we believe current market pricing presents a nice opportunity to add defensive exposures for balance portfolio’s at vastly improved levels.

Tax reform: Trumps legislative progress to date is essentially zero. Any actual tax reform should be severely reduced vs announcement if implemented at all

Tax reform remains a critical theme for financial markets. Recent announcements for reform made headline statements without giving much detail – classic Trump. When Trump was elected last year, JCB wrote extensively about the difficulties Trump would face enacting legislation with the ‘’swamp.’’ To date, material legislative progress has been missing in healthcare, the wall with Mexico, immigration bans and border adjustment tax. This is despite having control of both the House and Senate. Whilst all sides of politics agree the US tax code requires reform, finding a common path forward remains extremely challenging. We hope to see progress here in coming months but JCB continues to believe what will be delivered will not meet the markets grand expectations.

Careful what you ‘’Warsh’’ for – favored US Federal Reserve Chairperson Kevin Warsh looks to break recent relationships with equity markets

Kevin Warsh is the current front runner to replace Janet Yellen as Chair of the US Federal Reserve in 2018.  Just what the world needs, another multi billionaire (and family friend of Trump’s) deciding that fate for the rest of us. A Warsh Federal Reserve would be vastly different to the Fed under Bernanke and Yellen. Warsh has been publicly critical of current Fed policy (as has Trump) and believes the Fed has become a ‘slave’ to the stock market. This appointment is all speculation at this stage but investors should continue to monitor the composition of the US Federal Reserve into 2018.  These announcements are a potential source of significant market volatility.

Toys R Us bond holders lose 80% of capital – bonds from 96 cents to 18 cents on the dollar - a stark reminder about risk as credit hits cycle highs

Toys R Us bond holders suffered significant losses in September as the company filed for bankruptcy. The household name of 1990’s and 2000’s is no more in an Amazonised retail world combined with a leveraged balance sheet.  The classic joke of ‘’How did you go bankrupt?” applies in full here. The answer: “Slowly, and then really quickly’’ Their outstanding 2018 bond issue traded from 97 cents on the dollar to as low as 16 cents in September representing more than 80% loss of capital.

This serves as a stark reminder that credit risk is the biggest source of losses in fixed income and leveraged balance sheets need to be carefully considered and negotiated before investors lend money to corporations or governments.  Thankfully the Australian Government is still the envy of the world with low debt to GDP ratios and coveted AAA ratings.

These types of investor losses remind portfolio constructors, advisors and investors to be truly defensive and not find quasi products to play this critical portfolio function.  ‘’Bond like equities’’ received significant press coverage a few years back with market darlings like BHP, Telstra and Woolworths providing supposed stable dividend income streams.  Sever capital losses and/or dividend cuts have resulted inflicting unnecessary damage to retiree portfolios.  All the staff at JCB own growth assets and we do not diminish their critical role in portfolio’s but make sure ‘’caveat emptor’’ – buyer beware - is a consideration when choosing defensive final products – particularly when lending money (buying bonds).

Portfolio Update for September

AUD interest rate volatility ticked up for the month of September as we more than doubled the range from the moribund August period, a range of 37.5bp this month vs 15bps in August. September also included the quarterly expiry of the SFE futures contracts which historically provides some turning points in the market and this month was no exception. JCB was positioned for a selloff in interest rates around the in the early part of the month, however, we were forced to reduce the position following the hurricane’s in the US, dovish Fed comments, concerns over debt ceiling extension in the US and geopolitical events around North Korea (possible missile launch on North Korea national day) early in the month. JCB added exposure early in the month after triggering stop loss levels which was ultimately frustrating in the corresponding pullback that followed later in the month. This initially detracting from alpha generation early in the September versus the index. However, it is critical that JCB maintains a disciplined risk adjusted methodology in our process as we explore potential alpha generating opportunities within the portfolios, and when key levels are breached discipline must be followed to stay on process.

JCB added additional positioning in short dated rates into improved valuations later in the month as we continue to believe the RBA will have a very difficult time raising interest rates in the short term until additional employment slack has been removed and the inflation pulse picks up from below RBA mandated levels. We also added exposure to a new issue World Bank Supra position which we deemed cheap to fair value, which subsequently out performed 6.5 bp better versus the index and was a large contributor to alpha generation in the back part of the month.

JCB has also been running some curve steepening exposure which helped contribute the funds outperformance over the month - notwithstanding the initial necessary addition of exposure on geopolitical tension which proved a drag.

Looking ahead into Q4, JCB believes that market volatility is possible around the appointment of a new US Fed chairperson plus the composition of the Federal Reserve Board combined with the anticipated ECB tapering of its quantitative easing program. No doubt domestic and international politics and geopolitics will also continue to remain at the forefront of investors’ minds. We will continue to hold short and mid dated exposures and use our tactical overlay process to explore alpha opportunities as they present themselves.