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.

Some say that Australian's shut up shop in January and go to the beach, thereby making it an 11 working month year. From Hedge Clipping's experience that's a gross understatement. Many in the financial services sector, particularly when in Melbourne, advise that if you don't get deals in place by Cup Day on the second Tuesday in November, then getting any serious traction and attention becomes increasingly difficult. And even if that's a Melbourne issue, by the beginning of December many Australians go in to "count down mode" leading up to Christmas.

Without wishing to admit to being a member of the 10 working month a year fraternity, there's certainly truth in the facts. From December 1 onwards driving on city roads becomes progressively easier, politicians head for overseas taxpayer funded "research trips", and those left at the coal face endeavour to clear up all the outstanding administrivia we have been putting off for the past few months.

Not that it apparently affects the stock market, which according to an article  written by Wilson Asset Management's Chris Stott, argues that as the new year approaches, the market tends to perform particularly well as the Santa Claus effect, first documented in 1972, takes hold. Stott's research shows that since 1950, December has been the best performing month for the market, with the All Ordinaries index rising 74 per cent of the time. Over the period, the index has delivered average gains of 2.1 per cent over the month.

Bell Potter's Richard "Coppo" Coppleson describes the market hitting a "sweet spot" from mid-December through to early January. His research shows that during this period, Australian shares have posted gains in 31 out of the past 37 years to deliver an average return of 3 per cent. In the 31 "up" years since 1980, the market has increased an average of 4.2 per cent. Further, a remarkable 25 per cent of the time the market has surged by 6 per cent or more.

Since 1995, the All Ordinaries has fallen just twice during this trading period - once in 2007-08 (down 6.3 per cent) and again in 2010-11 (down 0.7 per cent). Analysis by Andrew McCauley of Veritas Securities finds that the market delivers inordinately high returns in the eight trading days before New Year's Eve, with the All Ordinaries rising a remarkable 83 per cent of the time from 1980 to 2015.

All this is great news for investors, but "why is it so"? Wilson Asset Management's Chris Stott goes on the explain it might be bank dividends:

"As investors make adjustments to their holdings and position their portfolios for the new calendar year they tend to be net buyers of shares as December 31 edges closer. Not to be overlooked is the fact that three of the four big banks all pay dividends in December.

This year, ANZ Banking Group, Westpac Banking Corp and National Australia Bank will pay out a combined $8.2 billion in dividends to shareholders between December 13 and 22. Assuming about 15 per cent of dividends are reinvested through dividend reinvestment plans, collectively investors will still receive almost $7 billion in cash to potentially invest in the sharemarket.

In spite of the additional buying occurring during this period, the absence of many market participants at their desks during the holidays has seen the volume of shares traded on the ASX fall markedly. For example, in recent months the sharemarket has had average daily volumes of about $5.7 billion. In comparison, over the last two weeks of December 2016 and the first week of January this year, average daily volumes dropped by 21 per cent to $4.5 billion.

In Wilson's view, the combined effect of investors' net buying and the market's constricted liquidity helps push share prices higher, creating a Santa rally at the end of the calendar year.

With the festive season upon us, investors may wonder if this year the sharemarket will bring them some cheer. With the outlook for interest rates to be lower for longer, many investors could be more inclined to reinvest their cash dividends into the sharemarket, rather than put them into term deposits with record low returns. Past experience would seem to give reason for optimism with the market outperforming on average over the holiday period."

That's enough from Hedge Clippings for now - there's a (long) Christmas lunch I'm due to go to....

Financial Services Royal Commission - double backflip with a twist.

Finally facing the inevitable, both the banking sector and the Prime Minister came to the conclusion that having at least some semblance of control over the outcome was better than none. Certainly better than seeing a couple of government MPs crossing the floor with a proposal for a banking inquiry which would have been far more extensive than both the industry and the government would have liked. You could argue, as Andrew Main did on Peter Switzer's website earlier this week, that there was little point in having a Royal Commission when most people already know what the problem is. However, the political reality was that the problem was not going away, and the banks in particular would much prefer the process now under the current government, than in the future under a potential Labour government .

Hence the reference to the "least worst option" - facing the reality that fighting the inevitable was not working, and was certainly not improving the general perception of a government on the back foot. Backflips - even double ones with a twist - are preferable to outright defeat.

Royal Commissions are dangerous, so understandably the government has announced one with a limited number (13) of terms of reference, and only allowed 12 months and $75 million for the as yet unnamed members of the commission to return their findings. In reality given that it is now December, and the Christmas break is coming up, that probably means only 10 months, or a change in holiday arrangements for those involved.

However the government has scored at least a partial win (the twist) by broadly including any "financial services entity" and by capturing the superannuation industry specifically - and we would guess the industry superannuation sector in particular, which to a degree still restricts members' entitlement to freedom of choice, and has persistently refused to accept independent directors or trustees in line with the governance requirements that apply to listed corporations. Given the importance of the superannuation system to the future financial well-being of so many Australians, this surely is long overdue.

From "Hedge Clippings" point of view it will also be interesting to see if the vertical distribution structure of financial products (managed funds) through bank owned product issuers, platforms and financial advisors, also comes under the Commission's microscope.

Of course announcing an inquiry, or a Royal Commission for that matter, does not necessarily lead to an outcome. It's worth thinking back to the Rudd/Gillard Government's "Henry Review of Australia's Future Tax System" which was not only hobbled by not allowing it to consider either the GST, imposing tax and superannuation payments to retirees over 60 years of age, or already announced personal income tax changes. Ken Henry's report made 138 specific recommendations, many of which we suspect have either been quietly buried, or remain "under consideration".

The RBA is good, but not a good forecaster!

The superannuation ideas of the super-rich were heavily featured in today's media, and we can't disagree that Australia's super pool, the fourth largest in the world, (which is significant not only in itself, but particulary against the fact that Australia only has the 13^th largest economy) creates an extraordinary pool of capital which could benefit other sections of the economy.

While we wouldn't disagree that it could be used as a source of capital for Australian businesses, this in itself would create a number of issues regarding eligibility and security of the funds. Hedge Clippings has no doubt that these issues could be resolved, but we would still argue that the allocation of a portion of superannuation funds to much-needed infrastructure projects would make an even better fit.

One such reason is that the long-term funding requirements of infrastructure projects ideally meets the investment timeline of superannuation funds. Another is that a relatively steady income stream of around 5%, or cash +3% would be attractive to both the project and the superannuation fund, particularly that portion currently held as cash or in government bonds.

Finally, if there were to be approved infrastructure bonds, any superannuation fund, including the SMSF sector which makes up over 30% of the total, could invest an appropriate portion, possibly with a taxation carrot or stick attached. Given that the allocation of SMSF's to cash is reportedly high at around 25% or more, funding for Australia's much-needed infrastructure requirements could be met with a win/win/win outcome.

Elsewhere this week a speech by Philip Lowe, Governor of the Reserve Bank at the Australian Business Economists Annual Dinner caught our attention, and gave an insight into the difficult balancing act that the RBA has been facing. Entitled "Some Evolving Questions", and referring to a previous speech he had given in 2012 entitled "What Is Normal", the Governor admitted that the RBA is still searching to understand: What is normal?

However on the economic front things are anything but normal, with low unemployment and solid employment growth, an increase in the wage price index of only 2% over 12 months, and an increase in average earnings per hour barely above 1%. As a result consumer confidence is low, particularly given that the level of household debt to income ratio is forecast to top 200% within a year or so.

The RBA is keen to raise interest rates next year but is unlikely to be able to do so. Even a small increase will put further pressure on consumers who are already struggling, although businesses are continuing improve margins on the back of low rates and productivity and technology improvements. But most of all, as a result of high household debt levels, the already cooling property market would have difficulty with any rate increase without any increase in household incomes.

Finally, the RBA is currently forecasting consumption growth of 3% over 2018 and into 2019 but what is normal is that the RBA's forecasts are overly optimistic!  For the past seven years they seem to have been fixated by a forecast in consumption growth of around 3.5%, with actual consumption growth failing to achieve it on each occasion.

And while talking of "What is Normal", 10 years ago today Kevin Rudd took over as Prime Minister, the first of five we have had since then. Maybe the new "normal" is a revolving door at The Lodge?

Ethics as an option?

Dr Simon Longstaff of The Ethics Centre (formerly the St James Ethics Centre) was quoted this week as saying he felt he'd been trying to sell umbrella's in a drought for the past 30 years, but that maybe it is now starting to drizzle.

Hedge Clippings presumes he means that organisations are starting to understand that ethics are important, and as such his wisdom and advice is now being appreciated - in some quarters - at least more than it was.

It is unfortunate of course that this has probably only come about as a result of some failures and the resulting embarrassment in the banking sector in particular, with the media having a field day with the CBA's money laundering, and various examples of market manipulation and rate rigging amongst the other banks. Suffice to say that if the rules on market manipulation in those markets were the same as insider trading in equities, there'd be some significant "holidays" being handed out by the courts, rather than hefty fines being paid by long suffering shareholders.

It is however a sad reflection on the real world of business that the good Doctor Longstaff and The Ethics Centre even exist. Most intelligent and reasonably educated business people - banker or otherwise - know the difference between right and wrong. The problem is they just don't feel the normal ethical rules apply to them, or that the reward is such that they couldn't care anyway.

We long remember the term "Commercially Naïve" being applied to anyone who put ethics ahead of profitability - and it was not meant as a compliment. That Dr Longstaff is now managing to offload a few of his stock of umbrellas is encouraging, but disconcerting that it is only to avoid the recipient getting wet, rather than not needing one in the first place.