Major Themes for 2018

In years to come, when looking back, (hindsight being a wonderful thing) there are going to be a number of dominant themes which affected markets in 2018.  One of those, namely the threat of impending increases in interest rates in the US, was clearly evident this week as Federal Reserve Chair Jerome Powell hosed down the market's hawkish expectations, resulting in a massive "relief rally" as equity investors, who had been nervous all year, pinned their ears back and pushed the market sharply higher.

Unfortunately one of the other big themes (or concerns) hanging over the market, namely the impending US/China tariff war, overcame their optimism ahead of the G20 meeting in Argentina. Welcome to Donald Diplomacy, Huff, Puff and Threat. Every war has an armistice, and in this case it remains to be seen if the initial skirmishes and threats prevent the war actually starting, or whether it will escalate come January 2019.

However, if the messages out of the G20 are positive, particularly if added to the Fed's more benign outlook, then expect a bumper Christmas rally to end the year.

In Australia, one of the great themes of the year has been the revelations from the HRC, with the final round of public hearings concluding today ahead of Commissioner Hayne's final report due in February. With the exception of Macquarie's Nicholas Moore, none of the bank CEO's or Chairmen did their (or their organisations') reputations any favours. In particular Ken Henry shone for all the wrong reasons when he presumably decided he'd had enough of copping flak, and was going to take a different approach. We'd rate his performance as a 9/10 for effort, and a 1/10 for success. 

The other theme for 2018 was falling residential property values. Combining the problems of the banking and financial services sector with an over-indebted consumer, an oversupplied market well overdue for a correction, and brakes put in Chinese buyers' access to credit, resulted in the inevitable correction which will no doubt continue for at least a year, and possibly more.

Finally, politics will go down (unfortunately) as a theme to remember for 2018. Be it The Donald, Brexit, or the revolving door at the Lodge, it is not encouraging optimism.

As we said at the beginning, hindsight's a wonderful thing. Predicting the future is fraught with difficulty, so we'll leave that to another day!

Just because a problem is obvious it doesn't mean it's going to be solved. 
 
Hedge Clippings would love to claim the above adage as our own and would also be more than happy to credit the author if only we could recall in which of the thousands of emails we receive each week we found it. In any event it struck a chord based on the chorus of negative possibilities and opinions that are currently doing the rounds.
 
It is worth noting that based on what we are seeing, reading and hearing we are more in the glass "half empty" than "half full" camp, and in one conversation with a "half full" (metaphorically speaking) investor over the past week we pondered which, if any, of the following scenarios might be more positive in 6 or 12 months' time than they are now.
 
Australian Property/Equities:
 
Problem: Negative influences coming from oversupply (units) and reduced demand (particularly from Chinese buyers), potential reductions in immigration, tightening credit from banks following the Hayne Royal Commission, low wages growth, higher mortgage costs as fixed deals turn to variable, higher US interest rates impacting bank's cost of funds, and reduction in negative gearing if there's a (likely) change in government next year.
 
Solution/Outlook: Glass half full, and a reminder not to listen to property experts who as recently as April this year couldn't, or wouldn't, see the writing on the wall.
 
Australian Economy:
 
Problem: The Australian economy is the envy of the world - growth forecast around 3%, low interest rates, low unemployment, but also a hostage to global, and particularly China's, fortunes. See above - if the property market weakens further it will impact significantly on consumer sentiment, spending, and thus unemployment. Any slowdown and the RBA has nowhere to move. 
 
Solution/Outlook: Glass half full. And then there's the federal election.
 
US Economy/Equities:
 
Problem: Rising interest rates, stretched valuations, The Donald, and after the recent mid-term elections no longer fully in control, potential expiry of tax and infrastructure short term "sugar pill", trade policy, Chinese tariff war.
 
Solution/Outlook:  Glass half full. Anyone able to predict "double down" Donald please let us know.
 
US/China Tariff War:
 
Problem: As above - who's going to blink first, Donald or Xi? There's a good chance that if it gets worse before it's resolved, Donald might have scored an own goal.
 
Solution/Outlook:  Could go either way. If solved expect a bounce, but could get worse before it gets better.
 
Chinese Economy:
 
Problem:  As above - the tariff war is likely to hurt China more than the US, it's slowing, although still a significant force. There's more than just the tariff issue at play, including mountains of debt.
 
Solution/Outlook: The government is doing everything it can - and they can do more than most to solve problems as they don't have to face elections - but they can't control everything. 
 
Brexit/Europe: 
 
Problem: The UK's previously dominant position as a (the) global financial centre is irreversibly damaged, and with it a significant section of the economy is relocating to the EU.
 
Solution/Outlook: Whatever the outcome, no one's going to be happy! Definitely half full, and a reminder that David Cameron must have had a brain snap when he announced the Brexit referendum!
 
In Summary:
 
In case you're wondering if we're alone in these thoughts, last night we listened to Dr John Hewson give his economic outlook at EY's Annual Hedge Fund Symposium. Being a self-confessed economist, he was able to quote reams of facts and figures which yours truly couldn't memorise at the time, or if he could, couldn't a couple of glasses of chardonnay later. However, it's fair to say he was definitely in the glass half empty camp.
 
For what it's worth, while happy to identify the problems, the good Doctor wasn't forthcoming on how to solve any of them either. How times have changed since he left politics!

Times are tough!

Markets remain tough. China is slowing ahead of the tariffs kicking in at 25% in January, the UK is anything but a United Kingdom, valuations (particularly tech and growth) are stretched, banks are tightening credit whilst the property market is awash with unsold units and an upcoming election next year could, and probably will, significantly change negative gearing, imputation credits and the labour market, the ASX is back to levels of 12 months ago, and volatility has spiked.

What makes a good fund manager in tough times?

It would be trite to reply to this question with the obvious answer "one who doesn't lose my capital", but in reality that's about it. However, the "why" and "how" behind the answer is less obvious. Given that markets are undoubtedly in the midst of tough times at the moment it is worth taking a deeper dive into a fund's quantitative performance and risk analytics to look behind the numbers.

This week we hosted a joint presentation from two different fund managers, Dean Fergie from Cyan, and Rodney Brott from DS Capital. Both are "boutiques", running concentrated portfolios and managing relatively small amounts of capital on behalf of both themselves and their investors. That gives a clue to one answer - invest with managers who have a significant amount of the own capital at risk alongside their investors and don't run other PA positions outside the fund. Both Dean and Rodney started their funds primarily to manage their own capital the way they'd like to, and so are literally putting their money where their mouths are.

Both funds have relatively small amounts of FUM by industry standards and as a result can not only be more nimble but can invest in smaller cap stocks without taking huge liquidity risks. Moving outside the ASX200 not only avoids the large cap stocks which are fully covered by brokers' and institutional research, and therefore are more efficiently priced, but also avoids the rising (and falling) tide effect of index and passive investing. It also increases choice, which of course can be a double-edged sword as it requires significant research to find the hidden gems amongst the dirt.  

Both have the flexibility to move out of the market to cash when deemed appropriate, although in practical terms this means generally in the range of 20 to 40%. "Appropriate" means not only when the market as a whole is risky, but also when they can't find quality companies in which to invest at attractive valuations.

Quality companies and attractive valuations means having a deep understanding of the sector, the company, and its competitors, and involves multiple company visits and "eyeballing" management as well as analysing their financials from which to finally invest in as few as 30 to 40 positions. Understanding was a recurring theme, not only understanding why to invest and what price represents value, but also understanding changes to their original investment thesis, or valuation metrics, and therefore when it is time to reduce or exit a position.

Speaking to one of the investors present at the lunch afterwards, the ability to sell a stock is where he felt the best managers have a real edge over the individual investor. Good managers don't use hope as a strategy, and when circumstances, news or valuations change, they're prepared to cut the position accordingly.

Finally, with approximately 58% of all equity funds having reported their October results, 54% of those have outperformed the ASX200 Accumulation Index's October return of -6.05%, whilst only 2% have managed to achieve positive returns. Of the funds that outperformed the market in October, the average return was -1.39%, with returns ranging from -5.94% up to +7.81%.

In October, global equity markets reflected investors' concerns, with the S&P500 falling -6.84% and flowing through to the ASX200, which also dropped -6.05% for the month. On top of September's decline of -1.26%, it was a case of thank goodness it's now November, and to date at least, a return to some kind of stability.

With only just over 20% of October funds in AFM's database having reported so far, there have been the usual wide range of results. Of those that have reported, just over 50% outperformed the ASX. Meanwhile only 10% have provided positive returns, with those not surprisingly dominated by fixed income, credit or managed futures funds, and NWQ's new global liquid alternatives fund of funds leading the way with a positive return of +3.51%. Other results catching our attention included Harvest Lane's Absolute Return Fund and ARCO's Absolute Trust, which fell only 0.11% and 0.68% respectively. While both results were marginally negative, it is unlikely their investors would have been overly disappointed.

Over 12 months to the end of October the ASX is now in negative territory, with many funds matching that, emphasising the point we always make that averages can be deceptive, and careful fund selection - and diversification - is vital!

Meanwhile this week, to nobody's surprise the RBA kept rates on hold, saving the property market from further stress. As usual there are those who are forecasting further falls, and others who take a more positive view, which we suppose is what makes a market!

Hedge Clippings is probably more in the glass half empty camp on property prices, although there is no single residential market in Australia, with a range of conditions in individual suburbs across each city that vary dramatically. In some, such as units away from the CBD, there have already been reports of falls in values of 30%, most probably reflecting a combination of oversupply and tightening of lending standards by the big banks. Elsewhere, where the supply and demand are more balanced, quality will no doubt prove the difference.

Our concern is this:  IF (ok, it's an IF) the economy falters in 2019 - possibly as a result of a change of government, and therefore policy changes such as the removal of franking credits, negative gearing, the final outcome of the Hayne RC, or simply a fear of the unknown - the housing market will fall further. If so, consumer confidence will fall with it, and the RBA will have little room, or the option, to cut rates.

Hedge Clippings was in Melbourne earlier this week, and amongst other things attended Super Ratings' Annual Superannuation Fund Conference and Awards. As our readers would know, Hedge Clippings and www.fundmonitors.com has a focus on the managed fund sector, rather than superannuation funds, but for obvious reasons there's a strong alignment, or at least a common area of interest, between the two.

It was, as usual, a well organised, informative and interesting event.  Labelled the Super Ratings "Day of Confrontation", it featured presentations from the CEO of Richmond Football Club, and also the new Assistant Treasurer, the Hon. Stuart Robert MP, who looked and sounded somewhat familiar. Although yours truly couldn't quite place him, we put that down to his relatively recent appointment following the unfortunate shenanigans within the Liberal Party.

Mr Robert was certainly forthright, and a strong proponent of choice when it came to employees being able to select where their superannuation contributions were directed. Just as well, for we also heard there are 622 superannuation products available in Australia and NZ, that 28% of accounts have balances of less than $10,000, and that one quarter of them are unsustainable.

As one of the panel speakers commented, 40% of the population have literacy levels that make understanding issues difficult, and financial illiteracy levels are double that. One was left wondering if member choice is actually a good thing, but as the majority of those in the room were from industry super funds, Hedge Clippings thought it wise not to raise that question - at least not out loud.

Mr Robert seemed to be on a verbal roll (he is a politician after all), but then surprisingly seemed to contradict himself by saying the best place to have been invested over the past 10 years would have been in an ASX Index ETF, which of course requires no active investment skills at all and would have lost 6% in October alone. This point was no doubt not well received by the assembled audience of award winning super fund managers and trustees, but we assume they too were too polite to question his judgement in this regard.

However, while we all like the idea of choice, it is not necessarily beneficial, particularly taking some of the points above; 622 products is one hell of a choice, especially if financial literacy is at best a rare commodity, and more than a quarter of accounts have balances of less than $10,000. One would have thought all those accounts could be collectively managed by the Future Fund, at minimal cost (or zero fees), whose returns have been close to double that of the average industry or for-profit super fund.

As noted above, we had trouble placing the strongly opinionated Assistant Treasurer, the Hon Stuart Robert. However, he seemed to pop up all over the place later in the week at all sorts of presentations and events, all in front (and centre) of the media. Eventually Uncle Google came to our rescue with this link.

He's the MP with a Masters Degree in Information Technology who has been charging the tax payer around $2,000 a month in home internet usage, totalling almost $38,000. We presume he had a choice of internet service provider, but judging by the cost, didn't do his research very well.

Market volatility - back with a vengeance!

Last week's Hedge Clippings briefly touched on market volatility (interestingly it was 19 October, the anniversary of the 1987 crash) and the risk of averages when grouping funds. Given the continuing volatility this week, and with the expectation of more to come, it's worth focusing on the best way to analyse a fund's downside risk.

There are a number of risk factors apart from volatility or standard deviation which are pretty well understood and known.  Basics such as maximum drawdown, % positive and negative months, worst month etc. are frequently used and quoted.

However a couple we look at that are neither well known, or it seems frequently quoted are Up Capture and Down Capture ratios. Put simply, a fund's up capture ratio over a specific time period (the longer the better) shows how much of the market's positive performance a fund "captures". And importantly given we're talking about volatile markets, the down capture ratio measures how much of the market's negative performance a fund captures.

The key to accurately measuring each is not to simply measure the average positive or negative performance of the fund vs. the market.  Instead, each is calculated by measuring the market's cumulative performance for all its positive or negative months, and then calculating the cumulative performance of the fund over those same months, and expressing that as a percentage, with a result of 100% meaning the fund tracks the index exactly.

For up capture, any number less than 100% means the fund underperforms in positive markets, and if the number is greater than  100%, the fund outperforms when the market is rising.

More importantly in the current environment, for down capture, a result less than 100% means the fund falls less than the market, while a negative number means the fund provides positive returns when the market falls.

Comparing and analysing funds is never easy, but by looking at the down capture ratios of different funds over various time periods will provide a useful guide when putting together a portfolio of funds.

Two important factors to remember of course are that the longer the track record of the fund, the more data points that are available to measure, and thus more instances of rising and falling markets - and secondly, that while a useful tool to understand a fund's performance, it is only past performance being measured.

For a moment this week it looked as if investors were going to ignore the market volatility of the past week or so, but overnight the US market put paid to that.  However, it is more likely that the conditions underlying the volatility - including rising US 10 year bond rates, falling unemployment levels raising the potential for a breakout in wages fuelled inflation, and the outcome of the US/China trade war - aren't going to change in a hurry.

Overlay these conditions with a market until recently trading at all-time highs, driven by low rates, improving earnings and dominated by tech stocks with stretched valuations, tax cuts flowing through, and an increase in infrastructure spending which is likely to run for the next decade at least, and it becomes less a case of potential for volatility, as a certainty.

Thus with the ASX200's Accumulation Index recording a negative return of -1.26% in September, and in all likelihood worse than that once October is done and dusted, the outlook for the actively managed fund space is going to be varied. Whilst index funds and ETF's will bear the brunt of the negative performance, falling in line with the market, we are already seeing the divergent performance of active funds based on September's results.

The average reported September return of funds in AFM's database is -0.33% almost 1% better than the ASX200, with 70% outperforming the market, and 32% recording positive results. Averages can be misleading, as the range of September's returns to date varies from +9.85% to -12.09%, the latter due to the market's rout in India.

While averages can be misleading, we all use them. After all, the performance of the ASX200 is the weighted average of all 200 stocks. We have recently analysed a range of key performance numbers over a range of time frames, and after wading through all the numbers one of the most telling results was just that: Averages don't tell the full story.

For instance, over the past 10 years, average annualised performance based on a fund's year of inception (with one exception) has been gradually increasing since 2007, while increasing dramatically for funds launched in 2017 to well over 25%.

Allocating each fund into quintiles based on performance shows an even larger discrepancy. Meanwhile breaking down each fund's performance based on their track record - Year 1, Year 2, Year 3 etc, clearly shows funds perform best during their early years - particularly year 1.

This has long been accepted, although not always understood exactly why. It raises the paradox however that although funds perform better in their early years, research houses, consultants, dealer groups and platforms traditionally insist that a fund has at least a 3 year track record - and in some cases 5 - prior to investing in or recommending them.

Whatever conservative or risk-averse logic is involved, the investor misses out on the fund's first three years - and their best period of performance.

Imitation is the sincerest form of flattery…

Here at Hedge Clippings we spend much of our week reading a wide selection of monthly reports and articles from fund managers. Then we spend at least some of each Friday trying to ensure we have gleaned enough of their market insight to gather our thoughts and try to appear coherent in our weekly musings.

For the past few months the Hayne Royal Commission, ably assisted by those in their sights in the witness box, have made our weekly subject matter a simple, if somewhat repetitive, choice. This week the market turmoil has put even badly behaving (but now we note, somewhat contrite) bankers in the shadows. While we would claim to have warned of some impending market volatility each week, we were never game to predict its timing.

So this week, rather than try to compose the "why" and "what next" for markets, we're going to simply reproduce an excellent, concise summary received from Marcel von Pfyffer from Arminius Capital whose intelligence and market savvy we respect. It is much simpler than trying to re-write it, with the risk of missing the point, or being accused of plagiarism. 

It is headed, somewhat disturbingly, The Next Bear Market Has Just Begun:

"For the last six months we have been warning our investors that the end was nigh for the US bull market which has appreciated by a colossal +423% for the S&P500 TR index from 6 March 2009 to 21 September 2018. Arminius Capital ALPS fund investors have benefitted from this since the fund's inception in 2014, until we became very concerned at the end of the first quarter 2018 and began to materially add to (increasingly expensive) hedges. The recent rises in US 10 year bond yields and falls in global equities have signalled that the long bull market is over.

The coming global bear market will not be like the GFC. It wasn't caused by a US housing bubble, it won't cause a US and European banking crisis, and it won't be limited to developed economies. But the US and other share markets will fall by 20% or more, many companies will go bust, and a recession will follow.

We can't yet predict how long this bear market will last. It may be over in three months (like the 1987 crash), or it may drag out for eighteen months (like the GFC). No two crises' manifestation or duration is ever the same. In Australia it will be complicated by the housing downturn and the retreat of commodity prices. Oil and gas producers, however, will do well. It will certainly damage all portfolios (individual investors, superannuation & pension funds, speculators & traders) which don't have short positions or derivative protection.

The Trump Administration has made the bear market worse by its foolish policies. The trade war with China is already increasing US costs and causing hardships to some US industries. Further retaliation by both sides will make matters worse and most likely not remedy the one fact the US, EU & Japan all have openly acknowledged and agree upon: that the global trade playing field is not level - in China's favour.

In particular, The Donald's decision to re-impose sanctions on Iran have propelled oil prices upward. The effect of sanctions will be to cut Iran's oil production from 2.5 million barrels per day to between 1.0-1.5 million barrels per day. China will continue to import Iranian oil, carried in Chinese ships, and Iran has four decades of experience in evading US sanctions. But there is not enough spare production capacity in the world to make up the lost Iranian production, so oil prices are rising, and may soon reach USD$100 per barrel again. US and Australian motorists are going to be paying more!

One of the reasons we are confident that the next bear market is under way is the behaviour of the technology sector. Tech stocks have led the way down in the US, and most of them do not have the earnings or dividends to justify a price floor. Over the last eight years, the tech sector has grown to make up 25% of the S&P500 index, so the sector and the index have a long way to fall. The big tech stocks - such as Facebook, Apple, Amazon, Netflix, and Google will still be in business, but they will be a lot smaller, just as they were after the dotcom boom and the GFC."

The Arminius Capital ALPS Fund is short several US tech stocks, as well as many other US, European, Japanese, and Australian stocks. Just as absolute return and hedge funds provided downside protection during the GFC (falling on average less than half the ASX200's -45%) we expect that once again these funds will perform significantly better than the market, and adhere to their ethos of long term capital preservation.

The hopes expressed in last week's Hedge Clippings - namely that the Hayne Royal Commission's final report due next February won't focus on increasing regulations, but will rather insist on accountability for poor - and possibly criminal behaviour - seem to have been given a good chance of coming to pass if the interim report is anything to go by.

Whilst we have to admit to only skimming some sections of the 1,000 page, three-volume interim report released last Friday, we have read enough to continue to be significantly impressed by its overall direction, and to see no reason we won't be equally impressed by the final version. Commissioner Hayne clearly recognises what the underlying problems are - namely conflict of interest, greed and regulators who need to act to prosecute - and prosecute hard from the top down - rather than to add ever increasing regulations on the industry.

If anything, removing existing carve-outs such as grandfathered commissions would be more useful than adding more laws.

Apart from the Commission's ability to put wrongdoers firmly in the spotlight, what the HRC has exposed is the previous difficulty encountered by customers when bringing their grievances to the attention of the regulators. We would expect the final report to also include recommendations regarding beefing up the FOS, or simplifying and speeding up the processes around it.

In spite of calls by the Federal Opposition to extend the HRC and the work of Commissioner Hayne AC QC, and his team, it sounds as if he'd rather finish it up as scheduled next February, and let the Government (hopefully) get on with the task of implementation of the recommendations.  Simply extending, and presumably finding more of the same, won't add to what's been uncovered already.

Elsewhere this week the US 10 Year bond rate reached multi-year highs as the Fed tightened again, with expectations of a further one or two moves over the balance of this year. The US economy is surging, and with unemployment sub 4% the question is when will inflation kick in, and at what level will 10-year bonds spoil the equity party? Anecdotally most fund managers we hear from believe a correction is overdue, but none are quite prepared to say when.

Anyone who has followed the goings on at the Royal Commission into Financial Services over the past six months or so won't have been surprised at the damning indictment of nearly every aspect of the banking, financial advice, mortgage broking or insurance sectors when Mr Hayne's Interim Report was delivered to the government earlier this afternoon. In fact unless you've been on the moon over the past six months you would have had a pretty good idea of the report's conclusion - the sector has been loaded towards the industry participant - the big end of town - and against the consumer.

It seems pointless to try to cover all but the overall gist of the lengthy 3 volume interim report. The real issue going forward is to what extent the politicians will actually follow through with the Interim Report's recommendations, even before the final version is delivered early next year. Early comments from the new Treasurer, Josh Frydenberg suggests he will take firm action, but without being overly cynical, he is a politician after all.  Maybe the upcoming election will ensure stern words are followed by firm action.

Meanwhile, untold damage been done to the standing and reputation of the financial services sector in the eyes of the consumer, although to many it merely confirmed what they perhaps already suspected. What it did fully expose was the massive conflict of interest between corporate profit and personal gain on one hand, and the best - or at least a fair and reasonable - outcome for the customer on the other.

Actual recommendations will no doubt be the subject of the final report, after Mr Hayne has grilled the CEOs of the various banks and other institutions, which we presume is due to take place in Round 7 of the public hearings scheduled for the last two weeks of November, under the overall title of "policy questions arising from the first six rounds". Whilst to date it is only the CEO and chair of AMP who have felt the full fallout of their time in front of the HRC, the bottom line is that responsibility for corporate culture ultimately lies with the board.

It is obvious that board and therefore company cultures over the last couple of decades have been slanted strongly towards the pursuit of corporate profit, achieved through an increased market share in the now well understood, but flawed concept of vertical integration, coupled with a system of commissions and bonuses which have created the massive conflicts of interest.

Where the balance lies between corporate profit, looking after investors, and doing the right thing by customers is difficult to judge, and probably even more difficult to legislate for. We just hope that the final outcome of Commissioner Hayne's report - be it the interim or final version - will not result in additional layers of excessive regulation, but will result in a clear delineation which allows criminal prosecution of the guilty parties where, and when it occurs.