JCB RETURNS +-0.05% (GROSS) YTD 2018, FOLLOWING ON FROM +4.68% IN CALENDAR 2017, +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• VOLATILITY EXPLODES IN FEBRUARY BANKRUPTING SHORT VOLATILITY FUNDS
• CREDIT ETF’S HAVE SYSTEMIC WEAKNESS AND CAN BE EASILY TARGETED IN THE RIGHT (ADVERSE) CONDITIONS
• GLOBAL DATA PEAKING – VELOCITY TURNED NEGATIVE AS HIGHER RATES ARE BITING
• STOCK BECOMES FLOW – QUANTITATIVE TIGHTENING STILL PRODUCES A MASSIVE BOND BUYER
• AUD RATES NOW BELOW US TREASURIES ACROSS THE CURVE ON DIFFERING CYCLE AND BUDGETARY OUTLOOKS

Volatility explodes in February bankrupting short volatility funds

The bankrupting of the short volatility fund XIV (Velocity Shares Daily Inverse VIX) in February is a classic market moment and could very well be the Bear Sterns peak behind the curtain before a larger Lehman crescendo. Now released, the volatility genie is unlikely to go back in the bottle as idiotic late cycle fiscal expansion in the US combined with higher global funding rates from the US Federal Reserve will have markets on their toes going forward. The now liquidated XIV product did exactly what it was designed to do, making a small amount of money each day being short volatility until in one single day everything was lost. Any ETF owners (particularly credit ETF’s) should be wriggling in their chairs right now, for the XIV was a complete victim of its own success. Having a public mandate to be one way only in a risky market combined with very large amount of money makes a product highly vulnerable to adverse market movements which force mandated short covering. The volatility community knew full well the thresholds required to trigger a XIV liquidation and surely helped themselves to a grand feast pushing volatility higher and higher until the XIV fund was forced to enter the market and cover risk at one off spike high prices, thereby guaranteeing its own death spiral.

Credit ETF’s have systemic weakness and can be easily targeted in the right (adverse) conditions

Credit markets often re price in an asymmetrical manner, we need look no further than Macquarie’s highly leveraged US infrastructure fund that recently lost around 40% of its value in a day after provisioning for higher funding and debt obligation costs (whilst an equity product the asymmetry is credit (debt) and funding related)  JCB has long argued that higher funding costs will be a huge problem for lower quality assets in a highly leveraged world, as higher funding costs create an income shock in the near term, but also lift refinancing hurdles over time. Warren Buffets famous quote of ‘’we will see who has been swimming naked when the tide goes out’’ is a great illustration for leveraged environment. In adding large US fiscal deficits to a late cycle environment, plus the addition or continuation of higher funding pressure via US rates hikes, the tide is most certainly going out right now for credit. Often at the end of the cycle we get a systemic shock, a company or group of companies that fail unexpectedly from sailing close to the wind. The danger for credit ETF’s comes from the massive credit liquidity gap that now exists between credit debt outstanding (which in the US has roughly doubled since GFC) and primary dealer inventories which have shrunk more than six fold. To put that in context the credit liquidity gap is now twelve times the size it was going into the GFC when credit products froze and where gated for long periods on one twelfth of the liquidity mismatch. The rise of credit ETF’s gives the market a host of products that they can collectively target in adverse circumstances, forcing them to rebalance into weakness (the XIV stop out above will look like a Christmas party) without any circuit breakers seen in equity markets. As funding costs are rising and liquidity is being withdrawn (see also LIBOR rates rising) investors need to think through liquidity sources going forward as the tide goes out, their own liquidity needs through this period and the asymmetry of some current portfolio holdings.

Global data peaking – velocity turned negative as higher rates are biting

Global economic data has been nothing short of great over the back part of 2017 and early 2018, however, the velocity of that data has now turned negative. That is not to say the data will not remain good, but markets price subtle changes quickly and global data has rolled from improving in 2017 to decaying in 2018. Are higher interest rates starting to bite? Almost certainly the selloff in US bond markets is having an impact.  Some isolated global data points of late include; US durable goods orders -3.6%,  US factory orders -1.4%, Germany factory orders -3.9%, global retail sales have been very weak, London house prices dropping at fastest pace since 2009 (Wandsworth/Fulham lost 15%), US mortgage applications -6.6%. Whilst many in markets are still discussing yesterday’s news of a weather effected January US employment report, data has been decaying quickly with a large geographical reach.  JCB retains its view that the US Federal Reserve will likely hike interest rates three times in 2018 (this alone will keep pressure on low quality risk assets via funding costs), however, the extrapolation of the late 2017 environment is short sighted by some market pundits which need to consider the ‘flow’ of markets rather than just focusing on the ‘stock’.

Stock becomes flow – Quantitative Tightening still produces a massive bond buyer

2018 is shaping to be a pivotal year. Political policy is changing, monetary policy is being normalized and asset markets will be asked to stand alone with less Central Bank intervention. Higher volatility is almost certain to remain part of the market construct making investors demand more in return for the higher volatility risk they must endure. Many in markets have discussed the withdrawal of Global Central Bank balance sheet accumulation under the phrase ‘’Quantitative Tightening (QT)’’. This term was first used in early 2016 when the Chinese Central Bank was selling $100 Billion Dollars of US Treasuries a month to stem capital outflow from China.  Many then wrongly assumed yields would rise sharply given the world’s biggest bond buyer (in China) had become a net seller. In fact yields fell and bonds rallied through this period as a ‘’flight to quality’’ bid emerged from the private system as other risk asset markets decayed.  Fast forward to 2018 and QT is again topical, as Central Banks have telegraphed a decline in balance sheet growth. However that isn’t the full story for the bond market, because the existing ‘’stock’’ of previous Quantitative Easing (QE) actually creates new ‘flow’. When bonds on central bank balance sheets mature, their proceeds have to be reinvested just to keep the ‘stock’ of balance sheet from shrinking. In other words, in QE the ‘stock’ generates ‘flow’ itself. And as the stock gets bigger, so do the reinvestment flows: in 2018 total QE reinvestment flows will be some USD $990 billion, vs USD $600 billion in 2016 and 2017. Those reinvestment flows already outstrip balance sheet expansion, with global central bank balance sheet expansion slowing down, reinvestment flows have already become larger than ‘new’ QE flows.

AUD rates now below US Treasuries across the curve on differing cycle and budgetary outlooks

2018 is shaping to be a pivotal year. Political policy is changing, monetary policy is being normalized and asset markets will be asked to stand alone with less Central Bank intervention. Higher volatility is almost certain to remain part of the market construct making investors demand more in return for the higher volatility risk they must endure. Many in markets have discussed the withdrawal of Global Central Bank balance sheet accumulation under the phrase ‘’Quantitative Tightening (QT)’’. This term was first used in early 2016 when the Chinese Central Bank was selling $100 Billion Dollars of US Treasuries a month to stem capital outflow from China.  Many then wrongly assumed yields would rise sharply given the world’s biggest bond buyer (in China) had become a net seller. In fact yields fell and bonds rallied through this period as a ‘’flight to quality’’ bid emerged from the private system as other risk asset markets decayed.  Fast forward to 2018 and QT is again topical, as Central Banks have telegraphed a decline in balance sheet growth. However that isn’t the full story for the bond market, because the existing ‘’stock’’ of previous Quantitative Easing (QE) actually creates new ‘flow’. When bonds on central bank balance sheets mature, their proceeds have to be reinvested just to keep the ‘stock’ of balance sheet from shrinking. In other words, in QE the ‘stock’ generates ‘flow’ itself. And as the stock gets bigger, so do the reinvestment flows: in 2018 total QE reinvestment flows will be some USD $990 billion, vs USD $600 billion in 2016 and 2017. Those reinvestment flows already outstrip balance sheet expansion, with global central bank balance sheet expansion slowing down, reinvestment flows have already become larger than ‘new’ QE flows.

JCB portfolio performance in February

JCB portfolios remained defensive in February, slightly underperforming indexes due to swap spread widening which caused short dated Supra positions to underperform. JCB also missed its key long term buy targets on the intra month spike in yields as we looked to add duration to the portfolio as valuations had improved,  before bond markets recovered and rallied from intra month high yields (lower prices). We did add a small amount of duration which quickly breached our internal expectations, and hence we cut this risk in keeping with our disciplined portfolio management approach and targeted better levels to lift durations. Our lower beta position caused a mild drag versus index into the recovery rally.