JCB RETURNS +3.06% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• “ALL GREAT LITERATURE IS ONE OF TWO STORIES. A MAN GOES ON A JOURNEY OR A STRANGER COMES TO TOWN.’’ LEO TOLSTOY
• IF YOU THINK THE US FEDERAL RESERVE STILL HAS YOUR BACK, MR AND MRS INVESTOR, THE WAY THEY HAD YOUR BACK IN 2009, 2010, 2011, 2012, 2013,2 014, 2015 AND 2016 … WELL, YOU MAY BE MISTAKEN. I THINK JANET YELLEN JUST BROKE UP WITH YOU. B. HUNT, SALIENT PARTNERS
• GLOBAL INFLATION IS MIA, ALTHOUGH AUSTRALIAN INFLATION SHOULD RISE DUE TO UTILITIES PRICES JUMPING. THE POISONOUS MIX OF RISING GLOBAL SHORT DATED YIELDS AND FALLING GLOBAL INFLATION
• BUILDING APPROVALS BECOMES CONSTRUCTION WORK DONE, MIND THE GAP
• OUTLOOK FOR AUSTRALIAN BONDS AS GLOBAL CENTRAL BANKS LOOK TO HIKE FUNDING RATES
• FUND PERFORMANCE

“All great literature is one of two stories. A man goes on a journey or a stranger comes to town.”
Leo Tolstoy

When we look back upon the financial excess into the GFC, the great bust and near financial Armageddon, the multiple bouts of global quantitative easing transferring private debt to governments thereafter, it will make a historic story for the grandchildren. Boom to bust to boom again within a decade, with reckless investors in the most part being saved by governments who facilitated in privatising the gains and socialising the losses. Did you actively manage that journey or did the quantitative easing stranger come to your portfolio?

If you think the US Federal Reserve still has your back, Mr and Mrs Investor, the way they had your back in 2009, 2010, 2011, 2012, 2013,2 014, 2015 and 2016 … well, you may be mistaken. I think Janet Yellen just broke up with you.  B. Hunt, Salient Partners

Since the GFC, Global Central Banks have provided a substantial tail wind for markets. June 2017 may well be a significant turning point for investors. If you take Central Banks at their word, they just packed their bags and walked out, not to return. Investors are on their own, albeit, at some of the highest asset valuations in recorded history. If ever there was a time for regret minimisation as an investor, now must be close.

European elections and political risks have passed, global data remains decent and markets remain calm, giving global Central Banks the confidence to begin removing the extraordinary stimulus of the post GFC crisis era. Central Banks of The United States, Europe, Norway, UK, and Canada are all openly discussing the removal of policy accommodation. Whatever form that may take (raising short dated funding rates, not reinvesting maturing bonds, reducing bond purchases) the net result is a contraction of financial market liquidity and a raising of the global cost of capital. Both of these measures are in stark contrast to the investment environment enjoyed since 2008.

The implications for investors after the extraordinary post crisis period should therefore be profound. For a decade a “buy any dip” and fade “volatility” was amply rewarded by markets with ever lower cost of capital and excess liquidity. This low volatility environment will likely give way to market based price discovery rather than CB controlled markets via asset purchases programs, and some asset classes should suffer badly under reduced liquidity. This is due to the “pricing cycle” effect in asset markets. Prices tend to go “up the staircase and down the fire pole”. Bull markets grind higher, gaining ground in small incremental moves. Investors remain optimistic and owning assets feels virtuous as income and capital gains make for healthy portfolio returns. Bear markets tend to be chaotic, as leveraged sellers are stopped out and forced to chase pricing lower, leading to a death spiral of lower pricing and reduced confidence until value is ultimately restored which encourages new buyers. Huge global debt burdens suggest this time will likely follow most historical cycles with similar transmissions from monetary policy through to investment markets.

Global inflation is MIA, although Australian inflation should rise due to utilities prices jumping. The poisonous mix of rising global short dated yields and falling global inflation

JCB has written consistently about Australia’s unique domestic issues that will be amplified by the moves of the US Federal Reserve. The addition of other major central banks to his reduction of global accommodation will add to the burdens of Australian households as the cost of capital the world over is pushed higher, restricting discretionary spending via an income shock.

JCB does expect near term Australian inflation to receive a one off boost from utilities price increases. This is an unwelcome development at a time when non-discretionary costs are already high. Housing has never been more expensive, whilst health care, education and utilities already place pressure on weekly pay packets. An income shock from higher funding costs should hit discretionary spending, and that will be sour news for the Australian economy into H2 2017.

Building approvals becomes construction work done, mind the gap

Australian building approvals continue to decay, falling -5.6% again in May and bringing the year on year number to -19.7%. Building approvals becomes construction work done, you cannot build without a permit. With 9% of Australia’s workforce employed in the construction industry, a circa 20% drop in building approvals is cause for serious concern. Development funding markets continue to tighten pushing developer’s costs higher. A loss of pricing power in real estate development can see futures planned projects mothballed, which can lead to a ‘mind the gap’ moment for the construction workers. This situation requires heightened monitoring for further development into H2 and beyond.

Outlook for Australian Bonds as Global Central Banks look to hike funding rates

Effect on markets comes with a lagged delay. Once the pause and access is complete the cycle either continues if growth allows, but also can see a reversals of policy due to struggling domestic economies under a higher cost of capital.

As we have already witnessed over H1 2017, long dated interest rates tend to remain stable or fall (increasing long dated bond prices) once Central Banks hike short dated funding rates (rates tend to raise before the hikes aka Q4, 2016) JCB wrote on this topic at length in our February and March 2017 outlooks available on the website jamiesoncootebonds.com.au. We recently re-examined our secular investment themes at our June Advisory Board meeting and remain confident that longer dated global interest rates will likely consolidate after a powerful and long trend. We continue to believe the RBA will remain on hold at 1.50% for the balance of 2017.

As we close the 1st half of 2017, Australian 10 year Government Bonds yielded 2.60%. The closing yield for bonds at year end 2014, 2015 and 2016 has been very close to 2.80% (actual yields have been 2.74%, 2.88% and 2.76%) As at the end of Q1 2017, Australian 10 year bonds yielded 2.70%. Our broad secular theme remains that bond yields will remain in a consolidated range during a benign period for the RBA, who remain very unlikely to move interest rates (raise or cut) in the near term, as bank funding rates tighten economic conditions in the economy making any RBA hike redundant. It is unlikely the RBA will cut barring an external shock or significant decay in housing or employment.

JCB believes the outlook continues to remain positive for risk adjusted returns in fixed income. Looking at historical returns data for Australian Government Bonds, it has taken active and consistent RBA rate hikes of significant magnitude to dampen bond returns in any calendar year. This type of action from the RBA in foreseeable future is extremely unlikely. We do note that historically if the RBA have hiked, bond returns are extremely powerful in the following 3 year period. In 1994 the RBA hiked 2.75% in 6 months pushing both bonds and equities negative in a tough year for investors. Australian Government Bonds went on to return 18.8%, 11.9% and 12.5% in the subsequent years of 1995, 96, 97.

In 1999, again the RBA hiked interest rates 1.50% denting bond returns, however Australian Government Bonds posted positive returns of 12.5%, 4.5% and 9.2% in years 2000, 01 and ’02. Again in 2009, after Government bonds providing more than positive 20% returns whilst equities posted circa negative 40%, the RBA actively hiked interest rates dragging on bond returns for the year of 2009. Bonds went on to post positive 5.2%, 13.4% and 5.5% in 2010, 11 and 12.

Are the RBA about to embark on multiple rate hiking cycle? Well if the last 100 bps (1.00%) of rate cuts over 2015 and 2016 has propelled the housing market by circa +30%, what would 100 bps of rate hikes do to property markets? And what would the flow on effects be for the economy? Add to this the multiple out of cycle rate hikes already pushed onto indebted borrowers from higher bank funding costs and JCB sees such a scenario as highly unlikely. Remember the pricing cycle is ‘’up the staircase, down the fire pole’’ and headwinds are building for many growth assets via the removal of global Quantitative Easing. That adjustment alone is reason to be cautious and embark on regret minimisation after a period of extraordinary asset returns from the lows of the GFC. JCB doesn’t argue for a particular asset tilt (that is an investor specific requirements depending on investor’s goals and risk tolerance) aside from always arguing for broadly diversified portfolios in keeping with modern day portfolio theory. We are likely to navigate unprecedented times soon enough, as the environment of the last 10 years is changing. Janet Yellen just broke up with you.

Fund Performance

The JCB Active fund returned -0.788% in June, outperforming its index by 0.294% on a gross basis. This brings portfolio returns to 2.93% for H1 2017.

The portfolio benefited from a short duration position, combined with a butterfly risk structure across the term premium which performed late in the month as global Central Bank hawkish speak re priced European Bonds, generating a pullback in Australian Fixed Income. This pull back brings valuation back to similar levels seen at the end of Q1, however at that time the market still held high hopes for legislative progress in the US and we had not added geo political risk into valuations via Tomahawks in Syria or tough talking against North Korea. As such JCB believes this improvement in valuation offers an attractive entry point given the sobering glide path we see for the Australian economy over H2, combined with heightened geo-political risk.