JCB Active fund is up 5.50 % (gross) since inception in Dec ’14 running a long only AAA and AA+ rated Government Bond Fund.

BOOM TIME EMPLOYMENT REPORT BUT CAPEX SHOCKER (AGAIN) AND THE MOST ANTICIPATED AND POORLY REPORTED RATE HIKE IN HISTORY

Where did our first year go? We only seem to have launched yesterday and yet JCB is into its 2nd year as a trading fund, having returned over 5.50% in our first 12 months investing in predominantly AAA (some AA+) rated Government Guaranteed bonds. This has vastly outperformed Australian equity indices and cash deposit returns over a similar investment period. So what’s is ahead for the 2nd year?

It may surprise you to know that Australian employment is booming. Literally ‘’o the charts’’ booming. According to the Australian Bureau of Statistics (ABS), employment in November has only been surpassed by the job growth of March 2012 and job growth of September 2004 - that really was boom time! So the 3rd best employment report in over 10 years?

Normally, at this point as an investor, I usually check to see if I’m standing on a trap door, but alas they are the official figures. We could almost ll the MCG with all the new jobs that have apparently been created in November alone. If you are wondering what to buy for your Kris Kringle this year, then buy a calculator, in the hope that someone might pass it to the ABS, because they sure can do with some help!

The ABS have been altering the seasonally adjusted data of late and we believe this has caused significant statistical noise to the data. Markets shoot first and ask questions later. This employment report hurt bond markets in November, recalibrating RBA expectations into year-end which also saw the AUD currency stage a meaningful rally towards 73 cents vs USD. Importantly the AUD is now back to almost unchanged levels from earlier in the year on a trade weighted basis. Most commentators discuss the currency vs USD, but over the year much of the move down from parity vs the USD was in fact USD strengthening rather than AUD weakness. This is really important as Australia doesn’t really trade much with the US anymore (aside technology, planes and medical equipment), with most of Australia’s trade partners being in Asia or Europe. Quantitative easing has seen both the JPY and EUR fall aggressively also this year, making the trade weighted basket value of AUD only mildly lower (RBA favoured measure of watching the currency).

To rebalance the economy, Australia needs a lower currency (trade weighted) and this is what will ultimately drive Mr Stevens and Co back to the rate cutting table in 2016. They are reluctant rate cutters no doubt, but the fundamentals win in the end and significant headwinds remain. In November CAPEX fell by 9.2% (ouch) following a fall of 4.6% in August. These are recessionary numbers with regard to business investment. Inflation (CPI) is at low end of the RBA target band and financial conditions are tightening via bank rate hikes on loans and a stronger AUD. Commodity and energy markets remain in free fall. Mr Steven’s suggested we ‘’chill out’’ ahead of the holidays. Last year in December the RBA’s official position was ‘’a period of stability (in rates) is warranted.’’ The RBA cut rates in February without any prior warning. So ‘chill out’ folks, nothing to see here on the domestic front, aside a little more economic decay……

Moving offshore the FOMC will raise short term interest rates on December 17th. This will be one of the most anticipated and poorly reported rate hikes in history. Anticipated because every media outlet around the world is obsessed with a Central Bank trying to hike interest rates (remember with ECB rate cut to negative 30 bps last week we are now at 691 rate cuts or stimulus programs globally since GFC) and poorly reported because most of the media reporting on the FOMC know very little about rates markets and the EFFECT of the policy move so will focus on the hysteria of the move rather than the implications and effects.

The FOMC rate cycle will be slow and shallow, because if it is not and rate move substantially higher the $57 trillion of newly created debt since the GFC will be at serious risk of default with chaotic consequences. That would make the GFC look a dressed rehearsal for the main event. The rate cycle must be shallow because any way we work through the FLOW of funds thereafter, the results all end at the same place, which is financial market pain. Let’s use the assumption that the FOMC hikes 100 bps over 2016. Short dated rates will rise (long dated rates aredriven by funding, inflation, GDP, supply demand etc not just FOMC). With a rise in short end USD rates, capital will ow into USD’s to earn carry (as most of developed world has zero or negative interest rates, thereby making the USD materially stronger). Domestically, the USD becomes less competitive with a higher currency and 40% of S&P equity earnings are based oshore so earning will decay.

Most of the $57 trillion in debt issued since GFC is denominated in USD, issued by emerging market countries. A stronger USD makes those debts grow, plus the rise in interest rates makes them harder to fund or service. As a result, emerging markets suffer. Commodity and Energy producers are based in USD, as is the Chinese economy with a pegged currency. Neither will enjoy a materially stronger USD, and so the flows become cyclical as the US economy cools, earnings suffer, emerging markets and commodities tank, bringing us right back to where we started. Addicted to financial stimulus.

When the FOMC hike in December the move will be accompanied by dovish language, re enforcing a wait and see approach on rates. We expect the FOMC to acknowledge a significantly lower terminal rate expectation than current market forecasts. Under this scenario, we see the rates complex being broadly benign over time within a tight valuation range, although large current short positioning can lead to a short covering rally in rates markets into year end and beyond.