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Rockanomics
ROCKANOMICS - August 2016
Setting up base camp?That might have been one way to describe equity market movements in August. An experienced mountaineer will tell you the importance of doing so - to recover, replenish and regroup (re-think even!). After all, the air starts to get really thin up there and a lack of oxygen most certainly leads to fatigue.
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What was?

Setting up base camp?

That might have been one way to describe equity market movements in August. An experienced mountaineer will tell you the importance of doing so - to recover, replenish and regroup (re-think even!). After all, the air starts to get really thin up there and a lack of oxygen most certainly leads to fatigue.

That said, globally, the MSCI All Country World index still managed 0.67% for the month. U.S. indices nudged ahead another 0.3% on average, with the biggest gains coming from the small cap sector. It bears repeating that the Russell 2000 small cap index has now rallied a whopping 31% from a February bottom, more than twice the gains of the large cap S&P 500! Thus re-enforcing our favoritism, over the past few years, for the smaller cousins at the top end of town.

Europe and emerging markets also eked out a 1% finish while Asia was the regional frontrunner, up 1.8% in August. The Middle East and Africa though, were collective down nearly 4%. Saudi Arabian banks are facing a liquidity crunch as the government withdraws deposits and sells local currency debt to fund an ever growing budget deficit brought about by sustained low oil prices. When you’re a nation of slick and sand and the former isn’t worth what it used to be (and your sand worth even less), this shouldn’t be much of a surprise. What might be, is their continued insistence (as head of OPEC) to keep pumping out record amounts of oil!

After a July slump, commodities attempted to resume a multi month rally only to see it fizzle by month’s end, finishing flat. A mirror rise in the US Dollar might have had a big part in that (as major commodities are priced in USD). Oil shot up 21% only to lose more than half of that as the black gold continues its manic, bipolar behavior, flipping between bull and bear markets (20% up/down) and leaving profits very slippery for investors.

Further proof of slowing demand and weaker trade took the form of the collapse of the world’s 7th largest container shipper (South Korea’s Hanjin) with apparently USD 14 billion of cargo (a lot of it Christmas goodies we hear) floating aimlessly at sea as the convoluted legal wrangling began. If Myer looks a little light on the shelves this season, you heard it here first.

After an arduous trek up from a February bottom, the Australian equity market took a breather and went down 2.8% in August. CBA and Westpac were hit hard while other staples like Telstra, BHP and Rio Tinto took a beating in their own right. Banks reported shrinking net interest margins and a rise in bad debt provisions, while iron ore prices remain subdued. Technology was the only sector to finish well and truly in the green. It should be noted that money is definitely making its way down under as the thirst for yield (any yield!) is driving investors toward our dividend generous corporations and AAA rated government bonds. This might also explain why the Australian dollar (down a little under 1% against the USD for August) has held its ground despite the RBA cutting rates to yet another all-time low, frustrating Reserve Bankers but happily allowing yours truly to still partake, in a bit of OzSale and ASOS.

Private Wealth saw positive finishes in fixed interest, international shares, Aussie micro and small caps. Asian large and mid-cap investment managers we’re tops this time, repaying our faith in a rebound of the region. Property, infrastructure and a couple of our alternative strategies underperformed this time around, but all in all and given our asset allocation, the positives and negatives played largely in our clients’ favour over the month.

What now?

August was certainly characterized by thinning trading volumes and marked decreases in volatility (and price swings). Granted we’re in the thick of the northern summer and most money managers might be working on their tans, a simple measure of price volatility (tracking the average daily range) has major equity markets at its lowest point in 2 years! And the one thing we know about very low volatility – it tends to precede periods of intense price moves. September is traditionally the month of that roller coaster.

The other thing to be extremely mindful of is the unusual and high degree of correlation exhibited between risk assets (equities) and safe haven investments (high rating bonds and precious metals), year to date. Central bank actions - leading to the slow death of yield via compression in fixed income interest rates coupled with broad based asset price appreciation - have also forced a growing number of investors (and their nannas even) to pile on risk in the form of junk bonds, emerging market debt and equities. Even as corporate profits continue to decline and leverage keeps rising. This is an imperative time indeed to ensure you have a good adviser and appropriate asset allocation. The ol’ saying - past performance is no reliable indicator of future performance - could ring truer than ever, over the coming 12 months.

And just when you thought they’d faded away into the annals of tired opera, the US Federal Reserve will be back in the spotlight in September with that overplayed aria– will they or won’t they? Apparently, that now even depends on which board member you speak to! So much for a central, unified response. But against a backdrop of such eerie calm (and complacency some might say) and the vast majority of the market positioned one way across several major asset classes, a surprise rate announcement could definitely spark a bout of considerable volatility, with the lead up speculation likely to do the same.

What's that?!

Bonds and interest rates. Or more specifically why do bond prices move inversely to the direction of interest rates?

Quite simply, if you are holding a government bond that pays 5% and interest rates move up so that similar (term) new bonds are paying 7% (fantasy in this current world but for the sake of illustration), from a demand and supply point of view, your bond suddenly becomes as desirable as a Russian Lada. Unless you find a sucker who still believes the Lada was the best thing even after the DeLorean, the price you’d get if you sold this bond is likely to be deeply discounted. Conversely if rates we’re to dip below your coupon rate, all of sudden you’ve got something akin to a 1962 Ferrari 250 GTO (we’ll not even close but you get the picture)!

You have to envy the person holding a 30 year fixed rate bond from the very late 80s!

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