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

• “IF I COULD BE REINCARNATED…’I’D COME BACK AS THE BOND MARKET, YOU CAN INTIMIDATE EVERYBODY’’ 1990’S DEMOCRATIC POLITICAL ADVISER, JAMES CARVILLE.
• IS THIS 1987, 1994, 2000, 2007 OR 2018? EXTREME POSITIONING AND SENTIMENT IN BONDS AND EQUITIES.
• INTEREST RATES ARE THE VIRUS THAT AFFECT ALL ASSET CLASSES.
• GLOBAL SELL OFF DRAGS AUSSIE BONDS LOWER DESPITE WEAK INFLATION DATA. RBA ON HOLD.
• SCENARIO ANALYSIS FOR HIGH GRADE BONDS IN 2018 – GETTING CHEAP IN A RICH WORLD

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a 400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”‍

JAMES CARVILLE, DEMOCRATIC POLITICAL ADVISOR DURING 1990’S.

Is this 1987, 1994, 2000, 2007 or 2018? Extreme positioning and sentiment in bonds and equities

The famed market crash years above all have one thing in common. Interest rate rises. US markets were either in the middle of rate rises or had experienced rate rises in the immediate previous period, which tipped the markets and economy over the edge. The current set up is exactly the same this time, but for one notable difference. Extreme positioning and sentiment in bonds and equities are at record levels. This massive one way bet actually performed extremely well over January, with both products hitting many year-end targets. This was a winning position, however, much of this has been driven by momentum rather than fundamentals, and hence prone to a violent correction. It is highly likely that asset markets experience a significant lift in volatility over 2018 which will test these extreme positions and investor sentiment. Whilst the global economy is currently doing well, the seeds of the next downturn have been sown (rates have been rising since BREXIT in June 2016). Is 2018 to be added to the history books as a crash year? This looks unlikely in the very short term, but later in the year it is possible. You can only stretch a rubber band so far before it snaps. Rate rises are stretching that band whilst investor positioning and sentiment remains extreme.

Interest rates are the virus that affect all asset classes

As the cost of global capital has been rising since June 2016, we have long argued that this will affect economies and markets in time, ultimately completing the market cycle. Rising interest rates are far more acute in a heavily indebted world. The implications for Australian investors are likely to be stark. Every Federal Reserve rate hike in the US has driven ‘out of cycle’ rate rises for Australian mortgage holders, already servicing record debt levels. With global funding rates likely to rise over 2018 lifting the cost of global capital, Australian consumers will continue to struggle, particularly at a time when housing is no longer a ready made cash machine providing paper gains.

Global bonds drag Aussie lower despite weak inflation likely, keeping the RBA on hold

The acceleration of global bond yield rises led by US Treasury bonds so far in 2018 is starting to give global equity markets cause for concern, breaking the near parabolic rise of some indices. As the markets and economies enter a late cycle environment, it will pay to watch moves in interest rates and critically credit markets for the signposts to other asset markets.

Australia data opened the year on the back foot with another significant miss on domestic inflation, despite a lower currency in the Q4 period, which should have supported tradeables inflation. We expect the RBA to remain firmly on hold in the early part of 2018, given the RBA’s explicit messaging in late 2017 around the noted employment slack of 0.6% (as the participation rate climbs, the slack remains constant despite employment gains) and structural subpar inflation outcomes below mandate. We believe it will take two inflation prints within the mandate band of 2 – 3% to move the bank towards a hawkish rates bias. For now, the improvement in valuations looks attractive given the carry (coupon income) available from current levels versus the RBA cash rate.

Scenario analysis for high grade bonds in 2018 – getting cheap in a rich world

Which asset classes are cheap? Historically assets are very expensive. To help you better understand the implications of rate changes and their affect on high grade bond returns, we have provided a scenario analysis for Government Bond markets for a 2nd year. Our view is that there will not be a RBA rate move over 2018, for aforementioned reasons, and hence this is our preferred Scenario A. However as some investors believe the RBA will hike rates in 2018, we look at a second possibility – an increase in rates of 0.50%, in Scenario B.

In the scenarios below, we have used historical spread data for the last 20 years, incorporating pre and post GFC markets. The generic curve points are valued versus the RBA cash rate and run through a normal distribution curve. In five of the eight outcomes, we have assumed bonds are cheap to historical normal distribution based spreads. We have two fair value or mean assumptions, and one of eight assumptions suggesting the RBA could be have an easing bias to cut rates after making a hiking error, similar to Glen Stevens in 2007/08. Stevens hiked into the GFC and had to cut aggressively thereafter.

Despite much media sensationalism, bond returns are positive in seven of eight scenarios. As an active high grade bond manager, we would hope to offer an eighth possible positive return if it could recreate its historical annualised alpha generation of 1.34%.

This scenario analysis is for the Bloomberg AusBond Treasury 0+ Yr Index (the index for used for our AUD strategies) and should not be considered the expected outcomes of JCB strategies. We cannot forecast expected JCB outcomes, and we are focused on outperforming the index based returns, given our track record in previous years our investment process, however we cannot guarantee these outcomes.

JCB performance to 31 January 2018

The JCB portfolios outperformed the index in January, declining -0.24% versus the index of -0.43%. The portfolios benefited from an underweight duration position combined with corresponding short positions in other sectors (known as butterfly positions), that added to performance from the increase in term premium in the ten year sector of the curve.

The Australian Office of Financial Management issued a new November 2029 Australian Commonwealth Government Bond (ACGB) line via syndication, drawing significant interest (A$21billion in orders) in late January, which we used to close its underweight duration and reduce its butterfly exposures.