Trump's Tariffs obscures bond and equity market risks - for now.

Trump's trade restriction deal is still a work in progress, but in typical Donald style it's all part of a bigger negotiation play, and possibly directed as much at the rust belt which helped him into the White House in the first place than foreign nations dumping steel on the US market. 

We're not sure his change in US tariff policy (now clearly aimed at China and Asian imports, although that's gone unsaid) will necessarily turn around that section of the US economy, which is also facing other significant structural and long term issues. However, whilst not agreeing with his economic logic, one has to give Donald the politician points for keeping to his electoral promises.

We also noted that when it comes to trade and tariffs, he's now saying the Mexican's are his good friends, along with Canada. How much steel and aluminium (or even aluminum) is required to build the WALL?

Meanwhile the bond/equity market two step has receded from the front pages* of all but the financial press, but it is still there. As per this report from HSBC's Steven Major this morning:

"Our view is that the correction in risky asset markets (equities) should be taken as a warning of what could follow," Major wrote in the report. "Historical correlations between asset classes are unlikely to be stable as the global economy adjusts for the normalisation of unconventional monetary policy."

We've written about this for a while, but this chart from Deutsche puts it all in simple terms. As they say, a picture paints a thousand words...

This chart was produced before Trump's announcement on tariffs, but the key boxes are "An unfavourable rise in interest rates" and "Lower stock prices". Don't ignore the message!

In breaking news it has been announced that Donald Trump and North Korea's Kim Jong Un will meet in May - refer above to Trump's negotiating style rather than political skills.  There will be plenty of claims to bringing this historic meeting about, firstly from Trump himself by ramping up both rhetoric and sanctions, but also China for the pressure they've brought to bear behind the scenes. If nothing else it will put two of the most distinctive global haircuts into the same space at the same time. 

*So too, thankfully, has Barnaby's maybe baby and the PM's "bonk ban". The wider world must be wondering what life down under is all about.

Increasing turbulence as headwinds become tailwinds…

A combination of Jerome Powell's first major public appearance, and a typically Trumpesque announcement on steel tariffs, managed to further unsettle jittery markets overnight. As a result on the first day of March the US market declined for the third straight session,with the Dow falling 1.7%, and the S&P500 having declined 3.9% in February and when it moved more than 1% on 12 out of a total of 19 trading days, interestingly more often rising than falling when doing so.

Taking Powell's comments first - after all, they are likely to be somewhat more rational and considered than those of his Commander-In-Chief's. His comment that headwinds have become tailwinds set the tone, and as a result created headwinds for the market. Acknowledging that the FED's role was to create a balance between inflation ("expect to see it" increasing towards trend) and growth, Powell noted that while there was no evidence of overheating in the economy, US unemployment has fallen from 10% post GFC to its current level of 4.1%, with wages growth at only 2.5%, although he's also expecting that figure to increase.

What's always curious for those with grey (or no) hair amongst us, and those with memories of the '70's and 80's, is that the FED is actively trying to encourage inflation.

The market has little doubt that interest rates in the US will increase over the course of the year, with most analysts expecting at least three hikes, and possibly four, over the next 10 months. All eyes therefore will be on Powell's next major test, namely the FOMC meeting scheduled for 20th and 21st of March. Markets dislike uncertainty, and with the 10 year bond rate having climbed to within five basis points of the psychologically important 3% mark, the view remains that volatility will continue and the risk for both equities and bonds will remain on the downside. It is well worth remembering that for the last eight times when the FED has moved to a tightening cycle, lower P/E's have been the result.

Never one to be outdone, Trump (we'll resist any further "hair" comments as being a cheap shot) added fuel to the recent volatility by announcing a 25% tariff on steel imported into the US, and 10% on aluminium, each for "a long period of time". Even though steel and aluminium represent only a little more than 1% of overall US imports, the fear is probably greater than the fact. Trump is signalling, threatening or risking a trade war, or a response, particularly from China.

Watch this space.

Goldilocks' equity market - the beginning of the end?

Overnight the S&P500 closed at 2,703 - and after the recent volatility, posting a 52 week high of 2,872 and a 52 week low of 2,322 for a range of 550 points, and a rise over one year at one point of 24%.

Even though there's been some volatility over the past 3 weeks, the broader US market is less than 6% off its all-time highs, and is still much closer to its recent highs than lows. Volatility, which had been dragging along at less than 10% for much of last year, has doubled to around 18% after spiking to over 40% earlier in the month.

US company earnings and profitability have been underpinned by super low interest rates, low inflation, and low wages growth, (albeit that low wages growth is not that great for consumer spending or confidence) which we recently heard described as a "Goldilocks" environment - not too hot, and not too cold.

So the stronger economy is good for corporate health and earnings, which in turn is good for the economy. So what's the problem? The high equity multiples and valuations might be justifiable based on the above fundamentals, but higher bond yields are not good for equity prices if the result is a shift out of equities.

The US economy will continue to improve because the above "lows" are not going to reverse overnight even if they're on the move upwards. Goldilocks is still happy! But careful of bond rates. The US equity market is yielding dividends circa 2.4% - 10 year bonds are now yielding 2.9% and heading over 3% sooner rather than later.

The question is when? Next week sees Jerome Powell's first real outing as Fed chair - and markets will be watching that closely, even if another 3 rate rises are already expected before the end of the year. However, watch the bond market more closely. It is not that the US economy is not improving. Markets are driven by supply and demand, and if overall demand (asset allocation) is shifting from equities to bonds, maybe this signals the begining of the end of the Goldilocks era for equities?

On the local front one of Australia's most highly respected investors and fund managers, Platinum's Kerr Neilson, announced his intention to step down in June as MD and from day to day portfolio management duties. While some observers may fear "key person risks" may come into play given he has run the shop since inception in 1994, Hedge Clippings is not amongst them, partly as he'll remain a director and major shareholder.

Neilson has not only been a major contributor to the actively managed and absolute return sector, but he has created a business with $27 billion in FUM, and in doing so a culture and process which over the past 15 years has helped build Australia's global fund's management reputation. Modest, and lacking the ego often found elsewhere in the sector, we doubt much will change in style at Platinum as neither the culture, process nor people will change much at all. If that view is correct, neither will performance.

Markets stumble, then find their feet - for now…

The major story of the past week - or "non-story" depending on how you look at it - is that the sky has not quite fallen in (much like the member for New England) after the US market's sudden spike in volatility earlier in the month.

Inevitably there will be those who will be saying "what was that all about, it was just an over-reaction, and now there's a great buying opportunity!"

That may be, but as Hedge Clippings warned a couple of weeks ago, don't risk betting the house on it. The US market, having risen for 12 straight months, including over 5% in January, was approaching the "irrationally exuberant" stage, underpinned by low/zero/negative interest rates (depending on where in the world you are), the promise of US tax cuts and infrastructure spending, low inflation, and low wages growth, all of which are feeding into an improving economy and corporate earnings.

The canary in the mine is the 10 year bond yield at over 2.8% (and rising) vs the S&P500's 2017 yield of 2.4%, and an uptick in inflation. Perversely this is precisely what the FED has been trying to achieve. The renewed volatility (the VIX having traded around 10% for a large part of the last 6 months) was a useful warning shot across investors' bows, and luckily for them, the market seems to have stabilised - for now - rather than going into free fall.

While the economy and corporate earnings continue to improve, that won't fully insulate the market from an impending switch in asset allocation as the US10 year bond yield moves to 3% and above - which it will at some stage, and probably in the not too distant future.

Locally the damage to the Australian market was not as great, simply because in 2017 it had only risen half as much as the S&P500, but it still wasn't immune to the volatility. While it's only halfway through February, there'll be the usual wide range of fund results come the end of the month, but many absolute return funds had either short positions, or were carrying a high level of cash as at the end of January. As such their relatively low net market exposure will buffer them from the volatility, proving their worth in rocky markets.

US fed signals the course for 2018 as Janet Yellen is set to hand over the reins...

Outgoing chair Janet Yellen presided over her last Fed meeting overnight with a unanimous decision to keep rates on hold, but sending a clear signal that they expect "inflation to pick up this year" albeit that they also indicated that it is likely to stabilise around their 2% target. From next week Jerome Powell takes over, and given there was no change to the central bank's December projection of three rate rises in 2018, and with US economic growth described as "solid", it would appear that there is every chance of a .25% rate rise in March.

With yields on the 10 year U.S. Treasury bonds having gradually risen this year to levels not seen since April 2014, the time is approaching for a seismic shift or tipping point in asset allocations, potentially destabilising the long-running equity bull market. Of course the phrase "the time is approaching" is deliberately vague, and covers every possibility from months to years, thereby giving Hedge Clippings the opportunity to claim to have forecast the move correctly, at the appropriate time, when it in fact was inevitable.

However as far as the immediate situation is concerned markets pretty much took things in their stride, no doubt in large part because investors are already pricing in a rate hike in March, and at least two, or possibly three, over the balance of the year if inflation fails to stabilise, but continues to rise. While it is been stubbornly low since the GFC on the back of economic weakness and low wages growth,Donald Trump's tax cuts and infrastructure spending plans provide the potential for it to overshoot the 2% target.

While it is inevitable that eventually the bull market in equities will come to an end at some future date, what has yet to play out is the investors' reaction and how this plays out. History tells us that bull markets rarely end in a whimper - as evidenced by the spectacular falls in 2008 and 1987 amongst others. The added known unknown this time around is the effect that the massive inflows of the past few years from passive investments (ETF's) will have on a falling market. Just as an incoming tide lifts all boats, so too does a falling tide, exposing hidden dangers on the way out.

Having said that there are those, possibly with more optimistic views, that next time round it will be different: That the steadying influences of solid economic growth, aided by tax cuts, with benign wages growth assisted by advances in technology, will balance supply and demand to allow central banks (and markets) to hold a steady course. There is no doubt this possibility exists, but it is not one to bet the house on.

Over the past couple of weeks Hedge Clippings has looked at the returns of Australian hedge funds over 2017 - particularly equity based funds which on average outperformed the market -  returning +13.02% against the ASX 200 Accumulation Index 11.8%. However we also noted that averages were sometimes misleading, with many funds significantly outperforming the average.

Looking at similar figures from Eureka Hedge (based in Singapore and whose focus is global funds rather than Australian), the average global fund was only up 8.25% for the year, with 79% of fund managers in positive territory, compared with Australian funds with almost 93% in positive territory. Comparing apples with apples on a strategy basis, Australian equity long/short funds returned 14.23% vs their global peers performance of +12.39%, while in the long only strategy the locals again outperformed returning 17.05% vs. 16.85%.

These results are even more impressive considering the local market's underperformance compared to the return of 21.83% by the S&P500 where the bulk of global equity managers invest. So not only did the locals outperform their overseas peers and the local market, but the global industry underperformed the global market.

There could be reasons for this of course, one being that the majority of funds in the www.fundmonitors.com database investing in Australia have limited FUM, and rarely above $1 billion, compared to the many larger $5bn+ US funds, with high FUM historically leading to lower returns. However to a great degree it is down to the depth of quality managers in Australia, and a market which is under researched - particularly outside the top 100 or 200 stocks, providing significant opportunities for managers investing in companies that are travelling under the brokers' research radar.

However the bottom line reality is that there are some outstanding local fund managers, large and small, who consistently perform on a global scale.

Moving away from the subject of hedge funds for a moment, and given that it is the day before Australia Day, Hedge Clippings has been pondering whether as a nation we are making the most of our opportunities. Australia is often considered to be the "lucky country" with its abundance of resources, a great climate, and a multicultural and generally tolerant society which most countries would be proud of.

For instance, take the ridiculous and distracting argument about the date upon which we celebrate Australia Day, and even what it should be called. All Nations and civilisations have aspects of their past they might prefer had not occurred. However, instead of arguing about the date or trying to airbrush history, surely we should be using the day to not only celebrate our successes, but also redoubling our efforts to ensure that we have a fairer and more inclusive society for all - irrespective of past wrongs.

And at the end of the day what event has shaped this nation, warts and all, more than the arrival of the First Fleet, on January 26, 1788?

Australia may well be the lucky country, but I'm not sure we are very smart. When in the UK recently (hardly renowned as one of the sunniest places in the world) I was struck by the number of fields alongside motorways in which there were rows and rows of solar panels. At the same time the UK, along with many other nations, are looking forward by planning for the end of the internal combustion engine.

Solar and alternative power and electric vehicles on just two examples of where the average Australian seems keen to move, but is being restricted by political dogma and vested interests, not only of certain industries, but also of an unsafe seat in Canberra.

There's an old saying: "Unless you embrace change before it occurs, you will be decimated by it when it does!"

And on that note, we wish all readers a Happy Australia Day, however you wish to spend it.

Hedge Clippings enjoyed catching up on Sky Business this morning with an old colleague, and frequently quoted market commentator, Macquarie Wealth Management's Martin Lakos, along with Ric Spooner from CMC Markets. Discussing actively managed funds with a couple of market professionals who come from a different section of the market provides one with a different perspective, which is always useful. Amongst other things we discussed the underperformance of the Australian equity market over the past 12 months (actually over the past 10 years) compared with other markets, particularly the S&P500, and how Australian managed funds have fared in this environment.

Inevitably these types conversations tend to quote averages, which remembering the old adage that if "one's head is in the freezer, and toes in the oven, than your average temperature is comfortable", means averages can be misleading. However we did quote both the average return of actively managed equity funds in 2017 (+13.10%) against the return of the ASX 200 accumulation index at +11.8% which suggested they performed marginally, but not dramatically better. However as per the freezer and oven analogy above, there's a dramatic range amongst the diverse nature of Australian actively managed funds.

For instance, taking all funds and all strategies, the best performing fund returned 75%, whilst the worst fell 21%. The median return was 13.34%, with 55% of all funds outperforming the ASX200, and with 95% of all funds in positive territory. With this extreme distribution spread of returns, inevitably questions were asked: Whilst there was certainly a focus on funds investing in small and micro cap stocks, plus those with Asian or global mandates amongst the top performers, this was by no means universal.

Equally it is difficult for a manager to consistently perform in the top quintile year in, year out, but undoubtedly the best ones manage to do so, if not every year, then at least regularly. Another aspect discussed was that top performance does not necessarily equate to the best returns: Frequently what investors are looking for, particularly in the absolute return space, is effective risk management thereby resulting in limited drawdowns.

Further discussions ensued regarding fund flows - whether positive or negative. We were happy to report that fund flows were broadly positive, albeit they obviously favour the better performing funds. However when looking behind the reasons for increased fund flows, anecdotal evidence would suggest that self-managed superannuation funds, or at least their trustees, are significantly made up of baby boomers, who as a natural result of their age, or financial security, are now more risk aware and less focused on trading individual stocks on the market than they were 10 or 20 years ago. At the same time they tend to have significantly more capital to invest, either on a personal basis or within their SMSF.

The other great benefit of a properly selected portfolio of managed funds, apart from hiring the expertise required, is the diversification obtained as a result. With most actively managed funds holding between say 25 to 75 individual stocks, with careful selection of even just five funds, an individual investor can have exposure to 100 to 300 stocks across multiple sectors and geographical markets, providing excellent diversification of risk. Certainly there is not the individual involvement of market trading that many investors enjoy, but sometimes leaving it to the experts is a safer and more relaxing option.

With a new year beginning it is no doubt time to consider what's in store? Whilst tempting to think there's more of the same, things rarely work that way, but before we start looking into the crystal ball, let's take a look at the year that was:

From an Australian equity market perspective it started and finished well, but sagged in the middle before finishing up 11.8% on a total return basis. That's a reasonable return vs. cash, but it was the exceptionally low interest rate environment which helped explain a significant proportion of the equity market's performance.

Overall (allowing that some funds are yet to report their December results) the average return of all funds in AFM's data base broadly matched the market at +11%, while local equity based funds fared better at +13.97%. 

From a strategy perspective Long Only funds provided the best returns at +17.46%, followed by Long/Short and Equity 130/30 at +15.04 and 13.84% respectively.

Australian small caps with the big winners in 2017, particularly as the big banks and Telstra struggled. As a result those funds returning over 20% per annum tended to be focused on the small cap sector, or had a global or Asian geographic mandate.

On a global basis the Australian market significantly underperformed the S&P500's total return of almost 22%. One big difference between the two markets was that on average the ASX200 provided investors with a dividend return of 4.75%, compared with the S&P500 of 2.4%.

Looking forward: Undoubtedly on a global basis after 10 years of falling interest rates and central-bank support, equity markets have been, if not propped up, at least well supported. This environment however is coming to an end with interest rates in the US starting to rise in a (hopefully) measured fashion, whilst locally interest rate rises would seem to still be a few quarters away at least.

There's been much discussion in the media over the past couple of weeks with forecasts of more of the same for 2018, or alternatively the end of the dance party as interest rates increase. While there is certainly potential for that, provided the slow unsteady measured approach continues we would expect that equity markets, even though their valuations are stretched on a historical basis, will remain supported. However that won't go on forever, and at some stage there will be a switch in asset allocation. As ever, keep a watchful eye on the bond market, many times larger and more powerful than its attention seeking equity market cousin.

So if interest rates remain stable, or at least rise gradually, where do the risks lie looking forward? We would expect them to be political, both in Australia and overseas. Whilst Trump has reduced corporate tax rates to 21% in the US, he remains somewhat of a loose cannon - or should that be finger - either tweeting, or on the button. In the short term North Korea seems to have stepped back from the brink, but how long that may last is anyone's guess. In Europe Germany is not as stable as it was, and the whole Brexit fiasco is a distraction and has a long way yet to play out on both sides of the English Channel.

Closer to home, aside from political issues, it would seem that property prices will remain both a talking point and a significant risk, with household debt at record levels leaving the RBA with the challenge of a fine balancing act as and when the inevitable tightening cycle commences.

With only three more sleeps to go, Hedge Clippings can almost hear Santa's sleigh as 2017 draws to a close. Looking back over the year it was one of persistent and declining low volatility from an equity market perspective as low interest rates, low inflation, low wages growth, and steadily improving employment numbers underwrote business conditions and confidence, and thus market returns.

Conversely, Australian consumer confidence failed to follow suit. Low interest rates continued to fuel a surging real estate market - some would call it a boom - and massive household debt, but with no to low wages growth. As a result consumers aren't sharing the joy.

In spite of dire predictions from some quarters at the beginning of the year that investors would have to accept mid to low single digit returns in this environment it looks as if that may not be the case. To the end of November the ASX200 Accumulation Index has risen 9.81%, although less than half that of the S&P500's total return of 20.49%. Volatility, as measured by the VIX in Chicago spent most the past 6 months below 10, with a 52 week low of just 8.56. Not even three tightening's from the US FED, tensions on the Korean peninsula, or chaos in the Canberra sandpit managed to disrupt the market's party.

So where to from here in 2018? It seems dangerous to say it, let alone go to print, but probably more of the same. Improving business conditions in the USA will enable the FED's gradual tightening policy to continue. In Australia low inflation, low wages growth will see rates on hold probably until at least the 4^th quarter. In that environment, all things being equal, markets should remain stable, or at least continue their current course.

The danger is that all things rarely remain equal. While it is difficult to predict what might occur to upset the apple cart, the risk remains. Our best guess is something political, be it global or local. So while the weight of inflows remains firmly in the passive funds sector, so does the risk.

And why not? Active equity funds in AFM's database have outperformed the ASX200 YTD to November, returning 11.59% compared to the market's 9.81%. Of those almost 20% have doubled the return of the ASX200. Most importantly, with a couple of exceptions, they have done so with lower volatility than that of the market, even in the current "low vol" environment.

Do Lowy and Murdoch know more than the rest of us? Undoubtedly!

Last week Hedge Clippings discussed the potential for the $8 billion in bank dividends due in December being fed back to the market as a driver of a Santa Rally, although given the current negative publicity banks are receiving, it might not all necessarily find its way back in to bank stocks themselves.  This week came news which might herald a similar injection (or more) from Westfield shareholders, although a fair proportion of that might be re-allocated to the property sector.

Not content with the Lowy's taking a profit after over 50 years getting to, and at the top of their game, Rupert Murdoch's announcement overnight signifies there could be a move by two of Australia's most successful businessmen that there's something afoot.  Could this be the start of the smartest money in town taking a "little" off the table while asset prices are high, and the market is still buoyant, or is it just a co-incidence?

Hedge Clippings suggests possibly a little bit of each, along with a number of other reasons. Apart from both being incredibly successful on the global stage, neither are getting any younger, although there's no suggestion Murdoch is stepping back from the fray. Both have built and are/were at the helm of businesses which having benefitted from massive change over their tenure, are facing even greater pressure from a change in technology going forward. With nothing left to prove, why not cash in some chips while there are willing buyers?

In Lowy's case he also referenced the increasing burden of reporting and compliance in an increasingly regulated world which, while it might be necessary, has become such a feature of the corporate, and particularly listed corporate, world. Anecdotal evidence suggests that in many cases the risk and compliance role of a director of a listed company, particularly in financial services or any other heavily regulated sector, outweighs time and focus on strategy and direction. Given the CBA's current woes this may seem implausible, but that doesn't allow for incompetence.

For those readers in private financial services businesses we suspect the emphasis on the compliance and reporting requirements are also an equal or increasing burden, with few technological solutions to the problem. In fact advancing technology may simply be increasing the compliance burden.

Meanwhile, the US FED raised rates 0.25% as expected, even if the vote was not unanimous, and with expectations of three more to come in 2018, the markets were unsurprised.   Well that depends if it was the equity market - happy that the economic signals continue to gather momentum without undue inflation - or the bond market, unhappy as yields rise.  The question is when does the switch in asset allocation out of equities start?  Probably not for a while yet, but the tipping point will come at some point.

Labour markets and employment are strong both at home and the USA, but not so wages growth. That tipping point will no doubt change when labour markets go from being strong to tight, a scenario which will be delayed somewhat by advancing technology, but which the corporate world will not be looking forward to.