JCB RETURNS +4.68% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• FOR NOW FULL STEAM AHEAD, BUT ASYMMETRIC MONETARY POLICY SHOULD COMPLETE THE CYCLE IN LATE 2018
• RATES ARE RISING – BUT WHICH RATES EXACTLY? DON’T FIGHT ‘’THE FED’’ – IN EITHER DIRECTION
• 2018: THE YEAR OF THE USD – US GOVERNMENT 2 YEAR BONDS YIELD MORE THAN S&P
• RECKLESS STIMULATION - LATE CYCLE DEFICIT SPENDING IN THE US
• AUSTRALIA PERHAPS TO ENJOY A COMMODITY BOUNCE, BUT HOUSING AND CONSUMERS CONTINUE TO BITE
• BETTER TO REMAIN ‘ON HOLD’ THAN HIKE AND RETREAT LIKE RBA’S STEVENS (WHO COULDN’T READ THE PLAY IN 2008 LIFTING RATES INTO THE WORLD’S LARGEST FINANCIAL CRISIS IN THREE GENERATIONS)
• JCB DELIVERS +4.68% (GROSS) IN 2017 INTO AN INTEREST RATE HEADWIND AS THE DOMESTIC MARKET MOVES FROM EXPECTED RBA RATE CUTS TO RATE HIKES. DECEMBER 2017 MARKED JCB’S COMPLETION OF ITS COVETED THREE-YEAR PERFORMANCE MILESTONE. WE ARE PROUD OF OUR OVERALL TRACK RECORD OF PROTECTING ON THE DOWNSIDE AT A FRACTION OF MARKET RISK WHILST SIMULTANEOUSLY DELIVERING A STRONG ALPHA TRACK RECORD FOR OUR INVESTORS AT +1.34% ANNUALIZED IN THE MASTER AUD STRATEGY

For now full steam ahead, but asymmetric monetary policy should complete the cycle in late 2018

Markets finished 2017 on a strong note as global growth continued, and the Goldilocks environment of low rates, ample liquidity and fluid credit markets pushed risky asset valuations forward with powerful momentum. We caution, however as 2018 unfolds, investors should be mindful of the asymmetric nature of monetary policy.  Large cuts are required to generate a muted impact on the real economy, whilst slight tightening of financial conditions goes a long way to curtailing economic activity. With well known, documented and growing high debt burdens across the world, this phenomenon is amplified due to extreme indebtedness and the rise in the cost of funding and debt servicing.

Rates are rising – but which rates exactly? Don’t fight ‘’the Fed’’ – in either direction

During 2017, the US Federal Reserve (the Fed) raised funding rates three times (in March, June and December). Rates are indeed rising – but which rates exactly – specifically the short-end or the long-end? Markets expect further rate hikes in 2018 and have re-priced short-dated bond yields significantly (with US 2 year government bonds rising 80 basis points or 0.80% over 2017).  Meanwhile, longer dated yields have hardly budged in keeping with JCB’s major secular themes (with the difference between short-dated rates and longer-dated rates contracting as the yield curve ‘’flattens’’).  This dynamic looks set to continue into 2018 as short-dated international yields remain under pressure. The Fed seems intent on rising rates at a measured pace of once a quarter, which should continue to push shorter-dated rates higher and further flatten yield curves. It has remained futile to ‘fight the Fed’ and markets should continue to pay attention to the engineered slowdown which is transpiring.

2018: the year of the USD – US Government 2 year bonds yield more than S&P

Is 2018 the year of the USD? As global interest rate differentials continue to shift with short-dated interest rates in the US rising we would expect capital to flight into USD to seek higher incomes on offer.  One of the largest misses by market forecasters in 2017 was the selloff in the USD, despite ongoing rate hikes.  An easing of financial conditions is highly unusual as the central bank hikes interest rates, but the US enjoyed easier financial conditions over 2017 as a lower currency made the US more competitive combined with higher equity markets and tighter credit spreads. With short- dated bonds in the US Treasury market now yielding more than the dividend yield of the S&P investors now have a credible alternative to generate income using short term fixed interest securities.

Reckless stimulation - late cycle deficit spending in the US

As we enter the tenth year of recovery it is really quite staggering to see a fiscal push of $1.5 trillion dollars in unfunded liabilities (tax reform) taking the deficit to 3.5% of GDP.  Keynesian economists would argue for deficit spending during a recessionary period to stabilize the economy but to add additional fiscal spending in the tenth year of a recovery? There is little evidence to suggest such a move generates anything other than a short-term sugar hit for economies. In other words, this seems like reckless stimulation of an already strong but late cycle economy. US fiscal policy is acting as if the US is in the depths of a recession despite being at the peak of the economic cycle.

Australia perhaps to enjoy a commodity bounce, but housing and consumers continue to bite

The Australian economy continues to muddle along with below average growth, tepid inflation but robust employment. The start of 2018 looks brighter as the commodity cycle looks set to lift. However, this should be offset by a mild decline in capital city property prices driven by Sydney and Melbourne.  JCB continues to expect Australian consumers will remain defensive as ‘out of cycle’ mortgage rate hikes drive debt servicing higher over the course of 2018 into the higher cost of global capital.

Better to remain ‘on hold’ than hike and retreat like RBA’s Stevens (who couldn’t read the play in 2008 lifting rates into the world’s largest financial crisis in three generations)

JCB does not expect the RBA to move interest rates in 2018 (a continuation of our 2017 view). This follows as the underlying economic pulse remains below potential and monetary policy is asymmetric as above. The domestic economy will be curtailed by out of cycle mortgage hikes and macro prudential measures which is generating an orderly normalisation of housing gains in leading capital city markets. Rate hikes at this point would do significant longer-term damage to the economy and the RBA would prefer to hold than be forced to retreat into rate cuts quickly thereafter. Recall RBA Governor Stevens hiked interest rates in late 2007 and twice in 2008 into the largest financial calamity of three generations. What followed was a full about face with 300 bps of cuts in late 2008. Thankfully RBA Governor Lowe understands the asymmetry and is unlikely to repeat his predecessor’s shocking error which rattled consumer and business confidence unnecessarily.

Not all in the markets share JCB’s views. After the US, UK and Canada hiked rates in 2017 the domestic interest rate market moved from pricing a small probability of RBA rate cuts to pricing in an almost full 50 bps or 0.50% of hikes in early October. This was despite repeated RBA commentary that Australia did not go down the rabbit hole of near zero interest rates combined with Quantitative Easing and hence had nothing to remove from such an excessive emergency stimulation.  Despite sailing into the wind of such a re pricing JCB’s master AUD strategy delivered over 3.12% (gross) above the RBA cash rate whilst providing investors with needed expected negative correlations to a significant left tail risk event.

Portfolio update

JCB portfolios outperformed their benchmarks in December after taking a deliberately defensive approach to the year-end period. In particular, JCB were mindful of key market dynamics (such as low liquidity).  We retained a curve steepening position which benefited from a mild sell-off in yields.  JCB lightened spread exposures ahead of new issue supply (and hopefully supply concessions) which is often generated into the new calendar funding year for supra national issuers.

JCB remains constructive on the short-end of the AUD rates complex which is again priced for rate hikes in 2018 which is against our core views.

December 2017 marked JCB’s completion of its coveted three-year performance milestone. In investment management circles, investors tend to place weight on firms that can endure over this period, but also meet and surpass on expectations. On this count, we are proud of our overall track record of protecting on the downside at a fraction of market risk whilst simultaneously delivering a strong alpha track record for our investors.