JCB RETURNS +5.10% (GROSS) YTD 2017, FOLLOWING ON FROM +2.99% IN CALENDAR 2016 AND +4.94% IN 2015.

• VOLATILITY LIFTING IN HIGH YIELD AND JUNK BONDS. BE CAREFUL IF GREED SWITCHES TO FEAR
• AUSTRALIAN FRONT END YIELDS FALL BELOW US YIELDS FOR FIRST TIME IN 17 YEARS
• “STRAIGHT FROM THE RBA’S MOUTH… IF RATES WERE MATERIALLY HIGHER, THEN THE HOUSEHOLD SECTOR WOULD HAVE TROUBLE SERVICING THEIR MORTGAGES -- WE KNOW THAT’’
• DEFLATION – ARE YOU MAD?  THE IRONY OF INFLATION

Volatility lifting in High Yield and Junk Bonds. Be careful if greed switches to fear

As the year draws to a close it is a nice time to reflect on the investment environment and some of the ‘’experts’’ and their public investments calls for 2017. JCB has continued to argue that global rates are rising, but which rates exactly? Global funding rates are rising, which is a funding problem for another day, but long dated rates will be unlikely to move materially. As at the first day of December 10 year bond rates in the USA, Germany, United Kingdom, and Japan are essentially unchanged over 2017. Canada is a little higher and Australia a little lower. Our major secular belief remains that after a period of significant trend in long dated interest rates, the market will likely pause for an extended period of years building a consolidation range.

This total lack of movement over the year has left many ‘’experts’’ looking mighty stupid. They commented with great conviction that the bond market would generate vast losses in 2017 as global economic data improved, the US Federal Reserve raised rates and Central Banks removed policy accommodation. For those economists foolish enough to attempt the specific role of bond market strategy they have been universally butchered again. There remains good reason you don’t hire a carpenter to fix your plumbing.

The calendar year has provided strong portfolio returns across most asset classes. Momentum in risk markets remains positive, as does global economic data, however below the surface subtle shifts are appearing which are worth monitoring.

US high yield and junk bonds suffered significant losses and volatility in early November, (although they did bounce from the lows) to finish weaker on the month. This is a bellwether market to follow as it often leads credit delinquency at the end of cycle and this type of value indigestion bares monitoring. Much of the high yield and junk bonds markets recent performance has been predicated on significant investor risk appetite, prepared to lend money to companies with low credit ratings at slighter and slighter margins, despite loan covenants continuing to fall. Low quality, at lower margin with less backing it. Buyer beware. This investor appetite can turn very quickly if greed should turn to fear as seen by the nearly 3% straight line drop in prices early in the month. Chinese equities also suffered over November, losing 3% after the 5 year National Party Congress has passed, with Chinese economic activity having cooled significantly.

Australian front end yields fall below US yields for first time in 17 years

Short dated Australian bond yields have fallen below US bond yields for the first time in 17 years, reflecting the vastly different economic cycles between Australia and the US, as rate hike expectations continue to build from the Federal Reserve whilst expectation for any near term RBA moves remain mute. Australian bonds continue to perform after continued weak retail sales data, weak CPI numbers and political instability around dual citizenship crisis.

“Straight from the RBA’s mouth…if rates were materially higher, then the household sector would have trouble servicing their mortgages -- we know that”

RBA Deputy Governor Debelle follows in Governor Lowe’s footsteps on being extremely direct in answering questions. This a welcome change from Stevens who often flip flopped. When asked recently about the interest rate outlook for Australia, Debelle replied: “Are we just going to jack up rates to see how the household sector lives with that? I don’t think so. If rates were materially higher, then the household sector would have trouble servicing their mortgages -- we know that -- and you have to think about what the environment is that rates are going to be going up in, it’s going to be an environment where the economy is stronger…..I just don’t see that shock which comes along which causes rates to go up in an environment where those other things (i.e., stronger economy) aren’t the case. That’s been true pretty much throughout our history”. Australia will be a significant laggard as other global central banks tighten.

Deflation – are you mad?  The irony of inflation

A recent McKinsey and Co report suggests that as many as 800 million workers worldwide will lose their jobs to robots and automation by 2030. Robots never get grumpy, ask for holidays, seek a pay rise or need a Christmas party. With declining demographics already pointing to deflationary pressure, plus large debt burdens, lower unionization of workers and mobile pool of emerging world labour seeking developed world work, it is no wonder wage inflation still remains missing in the modern world.

But let’s assume it does show up for a period as many in markets are expecting in 2018.

Do we have asset bubbles? Bitcoin, US Equities, Junk Bonds, Property, Infrastructure, Art, Classic Cars, you take your pick (some economists who do bond strategy as a second job after hours can add Government Bonds – except unfortunately you always get your money back with income in time from a highly rated Government – they always forget that bit).

As many in the market are crowded into the inflation corner together like a herd, they are potentially missing the bigger theme. IF inflation returns, and that’s a big IF considering 6 of the last 7 inflation prints in the US have been below expectations and recent core PCE data is at lowly 1.4% YoY - it would ultimately be hugely deflationary. Herein lies the ultimate irony of debt fuelled bubbles. A rise in inflation would likely be greeted with higher funding rates on the world’s largest ever debt burdens, creating an income shock for all indebted households. The valuations of the above bubble markets are contingent on consumption to justify valuation and that consumption would likely crater, turning market greed to market fear. A bursting of any of these above markets would cause significant loss and pain and generate a major round of asset price deflation.

In pre-crisis markets we had two defined cycles – an economic cycle (which is really a credit cycle) and a monetary policy cycle in response. In post crisis markets we can add a third cycle in Quantitative Easing – this policy has been far too effective to go back into the bottle.

Large rally in bond markets as 2018 RBA hikes challenged

With almost two rates hikes from the RBA priced into bond markets in early October and the likely prospect that consumers will face higher mortgage costs into 2018, it is little wonder that Australian bonds rallied significantly over the month. JCB contacted a number of clients and made the argument that with short dated bonds at their cheapest levels vs RBA cash in 7 years, valuations looked compelling to add exposures as a large fire break of valuation had been established. The RBA continue to re iterate they remain happy with current policy settings and with bond yields at the cheapest levels vs RBA cash in almost 7 years the market bounced significantly over the month, despite US yields finished slightly higher over the month.

Portfolio performance – AUD master strategy above 5.00% YTD with further carry income to receive in December

JCB portfolios performed well over November generating strong absolute returns taking performance of our master strategy to 5.00% year to date in gross terms. JCB portfolios slightly underperformed the rally of the government index, as we continue to hold large exposures in the short dated bonds where we view the risk/reward and return as most compelling to own duration on an outright basis. JCB has lightened some supra allocations in favour of ACGB allocations looking towards some new issue concessions into early 2018.