JCB RETURNS +3.44% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• BINARY SET-UPS FOR MARKETS INTO DEBT CEILING (US GOVERNMENT SHUTDOWN) AND NORTH KOREA SHOWDOWN
• MARKETS TEMPER EXPECTATION FOR CENTRAL BANK ACTION, DOVISH FOMC, SLOW EXIT FROM QE FOR ECB DUE TO HIGH EUR
• $AUD RALLY IS HIGHLY DEFLATIONARY UNDER RBA INTERNAL MODELS
• HURRICANE HARVEY FLOODS TEXAS, DISRUPTING OIL AND GAS – ANOTHER DISTRACTION FOR TRUMP

Binary set-ups continue for markets into Debt Ceiling and North Korea showdown

As northern hemisphere markets return from summer breaks they are facing two major binary issues in 1) The US Government will run out of money by end of September and needs to raise its debt ceiling to continue functioning and 2) North Korea continues to antagonize the western world with weapons tests.

The potential for US Government shutdown will hang over markets in September. JCB wrote about Trump (Trump vs Congress) in our July monthly suggesting the president may hold Congress hostage on tax reform as a trade-off for passing the debt ceiling.  Trump commented during August that he may fail to extend the debt ceiling unless Congress passes his border wall funding and also added he may make Hurricane Harvey emergency repair funding contingent on the debt ceiling debate. This makes September a potentially dangerous period for markets where politicians will seemingly use whatever means necessary to push their personal agendas. Trump leverage here comes from the fact he has nothing to lose – he doesn’t face reappointment till November 2020. However Congress face re-election at mid-terms into 2018.

North Korea hostilities continue to threaten markets.  After being a basket case of the nuclear world for so long with failed test after failed test, all of a sudden within a year they have successfully tested long range ballistic missiles along with a supposedly miniaturised thermonuclear warheads.  Conspiracy theorists must assume they have had international help which suggests a greater game is at hand in time. Make no mistake as to the lethality of a possible strike – recent nuclear tests show a detonation yield of 120 kilotons. To put that in context the bombs dropped on Hiroshima and Nagasaki had 13 and 20 kilotons. The North Korean situation remains very difficult to price. Markets are taking a diminishing return view with each geo-political spike having a diminished impact in both time and price.  Such complacency seems fair until we escalate to a ‘fire and fury’ moment.

Markets temper expectations for Central Bank action in 2017

Markets tempered their expectations for the removal of highly accommodative central bank policies over the month of August. Dovish comments from US Federal Reserve members around the string of low inflation outcomes has lowered market pricing for any additional rate hikes in 2017. Probabilities based off Fed Funds futures markets now stand at only 34% for further rate hikes by the US Federal Reserve’s December meeting. This leaves egg on the face of many strategists and economic forecasters who were certain 2017 would deliver a round of rate hikes lead by optimism inspired by Trump.  JCB would argue that if not for the material cheapening of the USD currency over 2017, US economic data would already be significantly weaker and ironically it has been Trump’s failures as a president that have caused the USD sell off and allowed for economic activity and US stock markets to continue forward.

Whilst further rate hikes in the US have been pushed well out we do expect the Federal Reserve to commence balance sheet normalization in September, reducing the ~$4.5 trillion US Federal Reserve balance sheet by 20 billion a month. This has been well telegraphed to the market and we do not expect any material pricing movement as a result of quantitative tightening.

In Europe ECB Chair Draghi’s failure to use the Jackson Hole meetings in August to communicate near term removal of ECB stimulus. Draghi was adamant at the last ECB meeting he will continue printing 60 billion in QE until end of Dec 2017. The expected winding down of QE has been complicated with the EUR currency strength which is adding deflationary forces to the Eurozone economy, restricting the ECB from meeting their sole policy objective of 2% inflation.

Hurricane Harvey floods Texas, disrupting Oil and Gas – another distraction for Trump

The near term impact of Hurricane Harvey is both physical (damage to buildings and infrastructure) and indirect with the damages caused by people losing their purchasing power from the loss of employment. Around 100,000 homes remain flooded whilst oil and gas production facilities remain shut which has seen US retail petrol prices hit their highest level for two years. This has a near term dampening on US economic activity, followed by a lift as the rebuilding commences. The 500,000 vehicles that were damaged or destroyed will have implications for the broader economy as well.

The requirement for disaster aid for Hurricane Harvey will potentially expedite a deal being reached on the debt limit however the urgency for an agreement will distract Trump from other pressing issues and as such the likelihood of tax reform will be kicked further down the road.

Portfolio Update for August

AUD rates markets underperformed global peers over the month of August. Despite solid rallies from US and European bond markets, Australian bonds were little changed month over month. Intra month volatility produced a trading range of 17 bps in Australian 10yr bonds allowing for JCB portfolios to lock in some duration gains before resetting that risk at lower prices.

We had expected global markets to rally, and thereby Australian Bonds to perform well tracking with high correlations and as such positioned the portfolio to hold longer dated duration. This did eventuate after Korea fired a missile over Japan but otherwise Australian rate correlations were much lower than normal over much of the month. The strength of the AUD currency has effected flow of funds for AUD rates, seeing increased participation from currency sensitive sellers cashing in on a stronger AUD. JCB also retained a smaller allocation to semi government and supra holdings as we believe these spreads have tightened significantly and pricing doesn’t reward additional risk in spread based instruments. JCB has reduced duration holdings and will look to invest as opportunities arises over the month of September. As September is 1 of 4 contract futures contract expiry months we are sure to see some intra month volatility ahead.