IN THE SEVENTH MONTH VOLATILITY RESTED, IS THE FOMC NEXT?

After the surge in global market volatility throughout June and early July, another temporary resolution in the Greek debt crisis allowed markets to refocus attention on economic fundamentals. Unfortunately for Australia, those fundamentals continue to decay as our terms of trade decline and the broader commodity complex remains challenged, leaving the Q2 Capex report towards recessionary territory. This led RBA Governor Stevens to comment that trend growth may be significantly lower at 2.75% in years ahead, than estimated in the budget forward estimates which assume 3.25% moving up to 3.50% in 2017-18. Such an outcome would leave the budget ~ $170 billion in arrears vs current projections.

The decline in bond market volatility allowed additional exposures to be added in July after bond market valuations had reached compelling levels during the decline of June, and a calmer environment allowed for significant price gains over the month of July. This was further fueled by oil price declines creating renewed deflation fears. US data was weak over the month leading the market to push back on timing and frequency of potential Federal Reserve (FOMC) rate hikes. We have long argued that the FOMC wants to raise rates but the data will not allow it in any material way. As much as FOMC Chairman Yellen continues to say rate hikes are coming soon, the market continues to push back those expectations with current pricing ascribing only a 38% chance of a September move, down from 66% earlier in the year. Economists believe Yellen, with 82% expecting a September rate hike, although they assumed similar earlier in the year calling for a June rate hike back in April. Whilst we believe the data doesn’t allow for US rate hikes, they may eventuate regardless. It is important to recognize how different this cycle has been to previous history and acknowledge that any movement in rates will be extremely slow and orderly. Many well regarded pundits have estimated that if the FOMC hike rates into poor data and weakening commodity complex, they could be cutting again in 2016. Since the GFC the global markets have enjoyed 582 rate cuts or stimulus policy interventions.

We have had some notable rate rises in the developed world including the ECB hiking in 2011 (now followed by -20bps interest rates and a 1.2 trillion QE program. 1,200,000,000,000.00). The Bank of Canada, RBNZ and the RBA also raised rates post GFC. All three are now in cutting cycles. JCB retains the long held view that the FOMC may well pass on hiking rates at all in 2015 (although we acknowledge they do want a hike). We also continue to believe the RBA will cut rates in November following the release of Q3 inflation report. Any pullback in rates will remain buying opportunities given that the general economic data flow remains soft.

FUND HIGHLIGHTS & POSITIONING

AFTER THE MOMENTUM SELL OFF IN BOND MARKETS DURING Q2, THE FUND WAS RUNNING ITS LONGEST DURATION EXPOSURE SINCE INCEPTION. WE MAINTAINED OUR DURATION ABOVE 5.00 YEARS AS THE MONTH OPENED MOVING UP TO A HIGH OF 5.73 YEARS EARLY IN THE MONTH AS THE COMMODITY COMPLEX CONTINUED TO COLLAPSE (AS EXPECTED IN LAST MONTH’S MARKET HIGHLIGHTS).

The fund also benefited from weaker US data over July, changing the expected slope and speed of any FOMC rate hiking cycle. This repricing of FOMC expectations have made roll and carry paramount, as elevated forward curves have been challenged and some short positioning has been squeezed.

The market also enjoyed a strong seasonal bias for bonds as the northern summer sees issuance curtailed. European markets have negative net cash flows aided by ongoing ECB bond buying under QE at 65 billion a month. As the US curve started flattening early in month, we also closed all steepening exposure as the AUD curve displayed a technical triple top failure at 103 bps in 3s10s AUD curve. Further declines in the commodity complex and lack of any US wage inflation continue to favor long end rates and hence we maintain flattening exposure in the near term.

Over the month JCB has lowered its duration exposures to lock in absolute performance in keeping with our capital preservation mandate. This leaves the fund underperforming its index over July, however it remains significantly above the index over the YTD period.