Australian Market Summary (Issue 456) – July 7th, 2017

So, on the positive, unlike the past two years with BREXIT and the Greek debt crisis, I made it back from holiday and the market has managed to avoid any undue volatility.

Thanks to Guy for holding the fort in my absence and knocking together the past two weeklies.

Our market was a shade softer this week.

RISING BOND YIELDS

The major theme on investor’s minds right now seems to be the rise in ‘real’ interest rates, and this is acting as a drag on asset markets such equities.

Only 3 weeks ago we were making note of the heavy rally in global bond markets year-to-date, to the point that much of the concern for a rise in inflationary expectations post the election of Trump as President had been whittled from the market.

When we wrote on this only 3 weeks ago in mid-June, Australian 10-year bond yields had rallied back to 2.33% and were lower than where they were pre the US Federal Election.

At the time, Transurban (TCL) was still riding high at $13, Sydney Airport (SYD) was 10% higher, and all manner of long-lived asset companies were cresting a wave.

Yet as I type today, Australian 10-year bonds now yield over 2.70% and the likes of TCL and SYD are down over 10% from their highs.

THE UNWIND OF ‘QE’

The cause of this sell-off in bonds, both locally and globally, has been a burst of renewed economic growth and, importantly, increased caution by investors as to the impending unwind of what has been known as ‘QE’ or Quantatitive Easing in the United States.

At the last U.S. central bank meeting in mid-June, Federal Reserve officials confirmed that the bank would begin to unwind the US$3.5 trillion dollar expansion of its balance sheet that occurred over 3 stages in the aftermath of 2008’s GFC.

This is a big deal, arguably the biggest deal, for investment markets in the months and years ahead.

In simple terms, the Federal Reserve has spent the better part of 8 years supporting the global economy and its bond and equity markets by way of its purchase of both US mortgage-backed bonds and government bonds.

In effect, the Federal Reserve creates money out of thin air and then uses these funds to purchase bonds.

Those selling these bonds to the Federal Reserve, such as the U.S. government (to fund increased spending) or investment firms, could then use the proceeds to do as they wish.

In effect, this policy injected an unprecedented amount of liquidity into both the global economy and its asset markets.

The Federal Reserve became the biggest purchaser of the U.S. bond market.

Understandably then, in no small part, QE has had a substantial hand in the positive performance of bond, equity and property markets in the past 8 years undeniably.

The S&P500 has rallied 220% since the GFC, and U.S 10-year bond yields have remained as low or lower than the level of 2.50% they were at in the wake of the economic devastation cast by the GFC, in spite of 8 years of improving economic growth.

Later in the year, QE ends.

The plan is for the Federal Reserve to allow US$10bn in various bonds to expire each month, effectively withdrawing those funds from the economy on expiry.

The size of the bond expiries will rise as the months tick by, effectively removing more and more money from circulation.

For context and using the Federal Reserve’s outline for bond expiries, if all goes to plan, the Federal Reserve will see its balance sheet fall by $900bn from US$4.5 trillion currently, to US$3.6 trillion.

That means $900 billion of liquidity is removed from asset markets and the economy.

For context, when the Federal Reserve balance sheet was last at US $3.6 trillion, the U.S S&P500 index was at 1630, which is over 30% LOWER.

I have included a chart of the U.S Federal Reserve balance sheet, starting at US$1 trillion back in 2008, and showing how it ramped to the US$ 4.5 trillion of today.

Alongside it in orange, is the U.S S&P 500.

The chart shows just how closely correlated these liquidity injections have been with the U.S share-market.

And I repeat, it is set to reverse.

Rising bond yields make other asset classes look more expensive.

The biggest buyer of the U.S. bond market has now turned seller, and we should all take heed of this change in direction.

IMPACT IN MARKETS TO DATE

In recent weeks as bond yields have begun to tick higher, it has been notable that we have seen investors selling down winners.

NASDAQ stocks have begun to soften, European share-markets, where many professional investors are overweight and have benefited from strong gains year-to-date, have also eased by -4%.

In Australia too, some of the recent winners have begun to see some profit-taking occur.

This week, stocks like Magellan Financial Group (MFG), BT Investment Management (BTT), Sonic Healthcare (SHL), Transurban (TCL), Challenger Financial (CGF) and CSL (CSL) were all off around -5%.

All of these shares have been particularly strong gainers year-to-date.

CONTANGO GLOBAL GROWTH (CQG) – A STRONG START

An update to those investors that chose to participate in the CQG issue, you would be encouraged by the early gains made by the share.

CQG shares are now trading at $1.17 and the free option is worth 6c, putting the sum total of gains on your $1.10 investment at $1.23.

It is an encouraging start and indicates good retail support for the fund, but I would caution that this early excitement is likely to pull back in the near term since the stock is trading at around an 8-9% premium to its likely asset backing.

All the same, a good beginning.

AUSTRALIAN ECONOMIC DATA PRETTY GOOD

On the data front this week, the economic news was actually pretty reasonable and certainly confirms the stark contrast in how Australian businesses are travelling relative to their consumer counterparts.

The Australian Industry Group surveys pointed to continued strength in service sector and manufacturing sentiment, with confidence at or near their highs.

The trade balance rebounded strongly in May and was underpinned by a jump in both coal and LNG exports encouragingly.

Retail Sales too made a surprise and vigorous jump from what were 3-year lows in terms of growth, albeit I am not sure I am convinced of any sustainable uptrend.

I will leave it there for this week.

Apologies to focus so solely on the U.S Federal Reserve changes and the rise in bond yields, but it is a point of significant importance, and as timely reminder that the remainder of the year might prove slightly trickier than the start.

Have a great weekend everyone

Regards,

Jono & Guy

Financial Services Guide Update

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7th July 2017, 1pm

IndexChange%
All Ordinaries 5723 -57 -1.0
S&P / ASX 200 5683 -56 -1.0
Property Trust Index 1292 -25 -1.9
Utilities Index 8445 -264 -3.0
Financials Index 6423 -72 -1.1
Materials Index 9931 +130 +1.3
Energy Index 8569 -140 -1.6

Key Dates: Australian Companies

Mon 10th July N/A
Tue 11th July N/A
Wed 12th July N/A
Thu 13th July N/A
Fri 14th July N/A

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