JCB RETURNS +3.85% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• S&P DOWNGRADES THE AUSTRALIAN FINANCIAL SYSTEM AS PROPERTY PRICES FALL NATIONWIDE IN MAY; BEWARE THE OVER LEVERAGED
• HYBRIDS CUT TO JUNK AS S&P DO NOT EXPECT THE GOVERNMENT TO SUPPORT MAJOR BANK NAMES.
• DAVID COPPERFIELD (NOT THE ILLUSIONIST) CALLS THE OUTLOOK FROM 1849
• OBSTRUCTION OF JUSTICE OR OBSTRUCTION OF GREATNESS?
• “SELL IN MAY AND GO AWAY’’ WORKS AGAIN
• OBSERVATIONS OF BUYERS AND SELLERS IN AUSTRALIAN GOVT BONDS

Standard and Poor’s (S&P) downgrades the Australian financial system as property prices fall nationwide in May.

The downgrade of twenty-three financial institutions by ratings agency Standard and Poor’s (S&P) in May is a stark reminder of high debt levels creating excessive credit risk. The reasoning cited by the ratings agency was because the Australian financial system faced an ‘’increased risk of a sharp correction in property prices’’.  JCB has written extensively about why mortgage rates will likely continue to increase in Australia because of international forces beyond our control (‘’The Fed will continue to hike US interest rates, lifting the global cost of capital, a precursor to recessions in other cycles’’ JCB March monthly), adding further funding pressure to a system loaded to the gunnels with highly interest rate sensitive leverage.

Following on from a slight decline in Sydney house prices in April, Australian house prices posted their weakest monthly result in a while at -1.1% nationwide. Weakness was very much centred in the unit and apartment market, with the decline in Brisbane unit prices gathering pace (now -4.6% y/y) and Melbourne unit prices also now in negative territory at -3.8%. A combination of mortgage rate rises, increased regulation curtailing mortgage availability and potentially oversupply looks to be having an impact in these markets.

Hybrids cut to Junk as S&P do not expect the Government to support major bank names.

S&P does not expect the Government to support hybrid security holders if a big bank gets into trouble and as a result many hybrid instruments have been downgraded to junk. Investors should take note and reassess current portfolio allocations and portfolio risk/return in light of junk ratings on securities that JCB has long argued are more akin to preferred equity.

Equity-like characteristics of hybrids add significant risk to portfolios. They are subject to non-viability triggers, which means that if the Australian Prudential Regulation Authority determines that a trigger event occurs the notes will be converted to ordinary shares or written off.

Trigger events are designed to make hybrids the loss absorption instrument for financial institutions in conditions of financial stress including serious impairments and insolvency, both of which are rising in probability.

David Copperfield calls the outlook from the year 1849 (not the illusionist).

Higher global funding rates (higher US Fed Funds, potential lifting of depo rates in Europe, higher Shibor funding in China) will create stress and delinquency. Charles Dicken’s famed character David Copperfield knew that 168 years ago: “Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds and six, result misery.’’

For a large number of people, annual expenditures are rising, whilst they face the weakest ever recorded income growth in our nation’s history. The books don’t balance now and we have more funding pressure to come. Credit delinquency is building.  Arrears data continues to climb showing growing mortgage stress. The mathematics just simply don’t add up. We cannot have record debt levels (global debt grown from 140 trillion pre GFC to 230 trillion now) and expect that higher funding doesn’t matter. There is no economic escape velocity without cancelling the debt. Credit quality not only matters but is critical towards the end of the cycle.

Obstruction of Justice or Obstruction of Greatness? A swift impeachment would be hugely bullish for risk markets.

JCB believes a possible 46th President Mike Pence (orthodox Republican) would ‘’make America great again,’’ but only if he comes to power quickly.  Whilst an impeachment charge against sitting president Trump would be viewed market negative, JCB believes this would be hugely constructive in the medium term. Legislative progress under President Pence, an orthodox Republican, would be swift with Republican controlled House and Senate. However, as with many things market based, the themes are clear but the timing is difficult.  Midterm elections are fast approaching in 2018 with all 435 House of Representatives seats up for election plus 34 of the 100 Senate seats. Campaigning for midterms starts in November this year, making sizeable legislative reform unlikely from early 2018 onwards. The longer any Russia/Obstruction investigation lingers, the more likely Democrats can produce a large swing and change an all Republican majority as voters become disillusioned with a perceived criminal Republican leadership and a party polarised by infighting (Freedom caucus versus Two State caucus).

‘Sell in May and go away’’ works again for risk assets, but don’t believe the hype, stay diversified.

The adage ‘’Sell in May and go away’’ worked again for risk markets, with Australian equities suffering large drawdowns after S&P ratings actions against the financial system.  Philip Parker’s Altair Asset Management is concerned enough to close his equity investment funds and hand back hundreds of millions of dollars to investors. His reasoning is the prediction of a large property market unwind in Australia which he believes will lead a deleveraging cycle in other asset classes, namely equities.

Whilst JCB is sympathetic to some of these themes, this sell everything growth is an extreme position. A combination of growth and defensive assets allows portfolios to ride the tides and perform through uncertainty, both positive and negative. Modern day portfolio theory suggests being diversified in their portfolios and remain acutely aware of contagion risk.  Term deposits, corporate bonds (mainly financial in exposures), hybrids, negatively geared property and bank equity are all financial sector exposures at a time when there is clear evidence of decay and delinquency.

Observations of buyers and sellers in Australian Government Bonds.

Flows over the month of May remained positive for Australian Government Bonds with flow of funds data suggesting strong participation from Japan and Asian Central Bank community. Markets continue to lower estimations for terminal rate pricing from the US federal reserve, driving continued performance across medium to long term fixed income curves.

JCB has moved offices – our new phone number is 03 8580 0088.

JCB has relocated, and moved three floors upwards to Level 30, 101 Collins Street, Melbourne. In the interim our contact details will remain the same although our telephone numbers will be updated shortly.

Fund performance

JCB returns +3.85% (gross) YTD 2017, following on from +2.99% in calendar 2016 and +4.94% in 2015. In May 2017, the JCB Active Fund returned +1.03% (gross), underperforming its benchmark by -0.28%.

The fund was positioned underweight duration exposures vs benchmark in May (in keeping with our risk first investment process) into the large domestic risk event of the federal budget. We maintained this position into June as we believe the market is broadly at fair value given the known economic data to this point and we are happy to run less risk and protect capital in keeping with our primary fund objectives.

Over the month JCB reduced its holding in supra national bonds, taking profit after significant performance. These positions where initially upsized to protect against a near term lowering of Australian Sovereign rating (supras would remain AAA if Australia was cut to AA+), however, JCB feels this is no longer potentially imminent, therefore lowering our holdings in supras and increasing ACGB exposures.

We continue to retain a core position in supras for both carry and credit quality. We have positioned the fund to remain neutral on yield curve exposures at this time and await better opportunity to build positions at more attractive levels.