JCB RETURNS +2.75% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015

• LEADING CANADIAN MORTGAGE LENDER COLLAPSES, CRITICAL PARALLELS TO AUSTRALIA
• DOMESTIC TAILWINDS TO HEADWINDS, SYDNEY PROPERTY DROPS IN APRIL FOLLOWING GLOBAL DECLINES IN LEADING MARKETS.
• GLOBAL DATA DECAYS SIGNIFICANTLY VS EXPECTATIONS, MOMENTUM REMAINS NEGATIVE
• “I DO LIKE A LOW-INTEREST RATE POLICY, I MUST BE HONEST WITH YOU, AS SOON AS [RATES] GO UP, YOUR STOCK MARKET IS GOING TO GO WAY WAY DOWN” 100 DAYS IN.  DONALD J TRUMP, 45TH PRESIDENT OF USA.
• TOMAHAWKS AND MEGA BOMBS. GEO-POLITICS REMINDS INVESTORS TO BE DIVERSIFIED AGAINST LEFT TAIL NEGATIVE PORTFOLIO OUTCOMES
• OBSERVATIONS OF AUSTRALIAN GOVERNMENT BONDS BUYERS AND SELLERS

Leading Canadian mortgage lender collapses, critical parallels to Australia.

The Canadian economy has several striking parallels to Australia. Both economies are:

• commodity based primarily exporting to large trade partner
• experiencing rapid house price growth as interest rates were cut to counterbalance the collapse in the commodity complex
• beneficiaries of international property buyers (primarily from Asia)

The recent collapse of leading non-bank Canadian mortgage lender Home Capital Group Inc (HCG) is of serious concern. Are the foundations of the exponential rise of property prices starting to crack?

HCG is a non-bank lender who specialise in subprime mortgage lending. Last week the company was forced to borrow C$2 billion at penalty interest rates up to +22.5% to stem a deposit run which would lead to its insolvency. Bankruptcy or break up and sale appears inevitable, with the stock price off more than 83% in the last 12 months.

Is this Canada’s Countrywide moment? It is certainly a stark reminder that when the tail winds of momentum in property markets turn to headwinds, people and corporations sailing close to the wind will be exposed. All 4 members of JCB investment team were living offshore during the GFC and experienced first-hand how quickly liquidity can evaporate from markets, financial and property and the pricing damage that can be unleashed by forced selling due to inability to meet interest repayments.

For property to remain well supported 4 key elements must remain in place in some combination, however we see decay or risk in all the following:

1. Mortgage rates need to stabilise – we see this as unlikely because the Fed will continue to hike US interest rates pushing the cost of Australian bank funding and global capital higher (Aussie banks still source large amounts of funding in US). Decay
2. Credit creation needs to remain available -  APRA are tightening lending standards trying to slow credit creation. We have passed the point of easy credit but this is a delicate tight rope. Decay
3. Unemployment needs to remain low – high debt loads require constant servicing. Unemployment is critical to keeping the plumbing fluid. Risk
4. New participants need to enter the market – watch for a crackdown on international buyers in coming May Federal budget. This is an easy political victory, kick the crowd that don’t vote for you at the pleasure of the masses that do. Risk

Domestic tailwinds to headwinds, Sydney property drops in April following global declines in leading markets.

Domestically the rise in mortgage rates is starting to bite, with lower auction clearance rates observed and the first recent decline in Sydney house prices posted in April.  JCB has written previously regarding the headwinds from out of cycle mortgage hikes from Australian Banks placing pressure on disposable incomes at a time when wages growth is at the lowest ever recorded level. We believe only the financial effect of the December 2016 mortgage hike is currently in the market, with March mortgage hikes only now hitting April mortgage statements for the first time. Given the large debt loads and high interest rate sensitivity the domestic data should decay into H2 2017.  We expect that banks will continue to lift mortgage rates throughout 2017 as the Fed continue to lift US interest rates.

Global data decays significantly vs expectations, momentum remains negative.

Global data has taken a significant turn negative vs expectations, with the US Citigroup Surprise index dropping below zero for the first time since November 2016 (current reading -20 from +56 in March). First quarter US GDP growth came in well below expectations at 0.7% only, whilst US CPI was negative at -0.1% in April.  The US employment report also disappointed in April, dragging the 6-month average lower to +163k, well below the US Federal Reserve (Fed) target of +200k.  Despite this weakness in current data JCB still believes the Fed will lift interest rates again in June and September and then pause for the remainder of 2017 to assess the impact of lifting interest rates 3 times in the year – driving the global cost of capital higher and tightening financial conditions.

‘’I do like a low-interest rate policy, I must be honest with you, as soon as [rates] go up, the stock market is going way way down’’ D. Trump

100 days into Donald J Trumps presidency and so far, we have little but broken campaign promises. We have been critical of Trump promises, but we do agree with his above comment regarding the stock market being dependant on a low interest rate policy. This fits with JCB’s overarching secular thematic that interest rates will likely stay low for an extended period by historical standards, notwithstanding an attempt from the US Federal Reserve to lift funding rates away from emergency levels over the balance of 2017.

The change in positioning from Trump is dramatic - China is no longer a currency manipulator, healthcare is no longer a priority, interest rates are now preferred to remain low. JCB continues to believe that Trumps agenda will be partially delivered, albeit watered down and delayed in timing.

Tomahawks and mega bombs. Geo-politics reminds investors to be diversified against left tail negative portfolio outcomes.

April’s geo-political flares reminded investors that portfolio diversification is critical. Thankfully the North Korean threat remains just that at this point, however, we cannot discount further tension between the US and North Korea or Syria. Trumps show of force in bombing Syrian airfields whilst meeting with the Chinese leadership was good politics, but Trumps eagerness to control foreign policy outcomes using force on foreign soils re-energises geo-political concern and creates implications in the 2nd and 3rd derivative as Russia and China are drawn to support allies.  JCB expect (and hope) that these flares remain flashpoints without escalation, however the tail risk remains possible.

Observations of buyers and sellers in Australian Government Bonds.

Flows over the month of May remained positive for Australian Government Bonds with flow of funds data suggesting strong participation from Japan and Asian Central Bank community. Markets continue to lower estimations for terminal rate pricing from the US federal reserve, driving continued performance across medium to long term fixed income curves.

JCB has moved offices – our new phone number is 03 8580 0088.

JCB has relocated, and moved three floors upwards to Level 30, 101 Collins Street, Melbourne. In the interim our contact details will remain the same although our telephone numbers will be updated shortly.

Fund performance

In April 2017, the JCB active fund returned +0.602% (gross), underperforming its benchmark by -0.254%. This trims our YTD outperformance to +0.70% (gross)

The fund held underweight duration exposures vs benchmark going into April as the market had performed strongly out of the March Fed rate hike as expected by JCB (generating strong alpha in month of March).  The surprise US Tomahawk missile strike on Syria created a powerful flight to quality rally in bonds leading to the underperformance vs benchmark of the Active Fund, however this came on strong absolute performance.

The supra exposure we are currently holding also underperformed mildly into this rally, widening on spread by a few basis points, however this comes after strong outperformance YTD.  We have trimmed some exposure in supra’s, taking profit on these structures but continue to retain a core position for both carry and credit quality (these would remain AAA if Australia’s rating was cut to AA+). As the market retreated from geo-political shock highs in mid-April we added additional duration as global data has decayed materially, justifying additional exposure.

The fund remains neutral on curve exposures at this time and awaits better opportunity to build positions at more attractive levels.