Obviously the terrorist attacks in Paris were a horrible event. My thoughts are with all affected by them.
I did get many questions from friends and investors in my fund about what they meant for markets. My simple answer is you have to separate emotion from economic reality.
There should be no doubt the “shock value” of terrorist attacks is diminishing. It’s a terrible development but we are becoming conditioned to these events. 9/11 was in my view the most shocking and unexpected event in modern world history. We will all remember where we were when the twin towers fell.
Similarly, 9/11 was a major market event with the NYSE closed for 5 days and the investing world having to hedge risk (via selling) in markets that were open in the rest of the world. The Federal Reserve pumped liquidity via rate cuts and repos.
In the aftermath of the Paris attacks the world markets opened for business in an orderly manner, led by Paris’s CAC Index. In fact, S&P500 Index Futures which opened in Asian trading down -1%, rallied all day to close up +1.5% by the end of NYSE trading. They rallied another +1.5% last night.
The internal reaction in specific markets was to mark down companies in the European travel and tourism sector. Conversely, companies that produce defence sector equipment were marked up. That is a valid response to tighter border controls, general sentiment about the necessity to travel and an upgraded military resolve in Syria.
Outside of that the market response was calm, as it should have been. In fact by Tuesday, European equity indices had advanced sharply as traders placed further bets about the ECB expanding its QE bond buying programme.
I don’t want you to mistake me for some cold hearted commentator. However, as I said above, my job is to separate emotion from economic reality.
My view is the events in Paris and the most likely military reaction of the world in Syria/Iraq is not a reason to decrease exposure to risk assets. In fact, many other commentators I have read on the topic believe the increased determination to destroy ISIS will be a good thing for world markets (eventually).
What remains far more important to the future direction of world and domestic equity markets is Federal Reserve “lift off”.
As you know I think the Fed has done a TERRIBLE JOB in communicating its policy towards interest rate normalisation. Not only do they say too much, but too many Fed Governors blur the picture with their own views, which simply serves to deliver increased short-term volatility.
The fact the Fed didn’t raise rates at its September meeting played the key role in the equity market correction that followed, led by Wall St. The markets were worried the Fed “knew something they didn’t”, to which I argued in these notes was “absolute rubbish”. The Fed actually knows not much more than you and I. They are assessing the same economic data we all see and I remain of the view their communications policy is hopeless. Hopefully they can fix this a notch on December 17th when 81% of investors believe they will raise US cash rates for the first time in 9 years.
Markets are about confidence. Confidence is a derivative of leadership. The fact the Fed, the central bank of the biggest economy in the world, showed a lack of confidence, to even get the Fed Funds Rate (FFR) from 0% in September, triggered an equity market correction.
The Fed now has the chance to rectify that by confirming they are confident enough in the US economic trajectory to get the FFR off zero.
I believe the Fed funds rate rise on December 17th will prove a buy the fact event for risk assets. Why? Because it brings certainty after a year of uncertainty that has been reflected in elevated market volatility.
It is vitally important the Fed gets its message right. Nobody is scared of a 25bp rate rise from 0%, the world needs comfort on the trajectory of rate rises. If the Fed can convince markets any further rate rises will be at a “measured pace” then I believe the markets will buy that fact and rally into year end, potentially quite sharply considering how much cash is sitting on the sidelines.
Here’s something else to consider. The consensus view is the Fed will lift the FFR by 25bp on December 17th. However, the FFR is a range and the current rate is 0% -.25%. It’s been put to me by people who have insight into Fed thinking that it’s not out of the question the Fed lifts the FFR range by only 12.5bp to a new range of 12.5bp to 37.5bp. If that does happen you would see the mighty US Dollar fall and risk assets rise sharply, led by anything denominated in USD including the Australian Dollar.
It’s worth noting the move we have seen up in the US Dollar Index (DXY) is the biggest move ever before a Fed rate decision. My opinion is the USD is now 100% pricing the chance of a 25bp rate rise and a 25bp rate rise (or less) may well trigger a “sell the fact” event/“profit take the fact” event in the US Dollar.
If that happened you would see a short-covering rallying in the Australian Dollar, New Zealand Dollar, Euro and Yen. You would also see a short-covering rally in commodities and emerging markets. US equities would outperform European and Japanese equities, while Australian equities would also catch a bid into year end.
As most of you are most interested in Australian equities I thought I’d share my views on what happens from here in the ASX200. To recap from what I wrote in last week’s Switzer Super Report:
Quite clearly, the ASX200 has had the perfect storm against it in 2015, suffering not only from losses in its heavyweight index components, but also the double whammy fall in the AUD/USD cross rate.
The ASX Twenty Leaders Index (XTL) has been leading the broader market low. BHP & RIO in the miners, WPL, ORG, STO in energy, the four major banks, WOW and TLS has played the major role in our index underperformance of the world.
Some of those falls are driven by earnings downgrades and others by large scale equity raisings/dilution. Some by both.
In the last month alone we have seen another earnings downgrade from WOW, equity issues from ORG, STO and WBC and a very unfortunate dam collapse for BHP in Brazil which saw BHP fall to a fresh 6-year low.
Quite frankly the description of “perfect storm” is correct in large cap Australia, but it is always darkest before the dawn and I am trawling through the damage looking for contrarian large cap ideas in Australia to add to my portfolio. I think the ASX200’s -19% underperformance of Wall St in USD is now too wide and I expect the equity issuance pressure on the ASX200 to ease a few notches into calendar year end.
As you know my fund has been running pretty high cash levels but I am starting to see specific opportunities in Australia where I can see a prospective total 12 month return well better than cash, remembering the risks to the RBA cash rate remain to the downside in 2016.
A week later I have put some more money where my mouth is, increasing our funds exposure to Australia via derivatives and stock specific exposure because the technically important 5000 index level held again.
Our view is the ASX200 can get back up around/above 5400 by late January ahead of the February interim reporting and dividend season. On that basis we have sold ASX200 Index puts at 5000 and bought ASX200 Index calls at 5300. Interestingly the put we sold was more expensive in premium than the call we bought. We got net paid by the option market to take this upside risk. That shows you how bearish option traders had become.
That option position, known as a risk reversal, starts making money as time decays and the market bounces. The reason for derivate overlay is to make sure you capture upside when it comes.
As I wrote to you last week we are building a position in Telstra (TLS) and we continue to do that earlier this week feeling the knife has finally stuck in the deep value/yield support floor. TLS looks to have bottomed to us.
We have also increased our position in Macquarie Group (MQG) feeling the staff selling window and market pullback gave us a chance to buy MQG’s earnings growth profile at a discounted price. MQG should also give us leverage to any year end global equity market rally.
And finally, it does appear that confidence in Malcolm Turnbull’s leadership is translating to consumer confidence and employment growth. It is worth noting Australia added 40,000 full time jobs last month and the unemployment rate dropped below 6%. This is undeniably good news and led to my investment team and I adding another Australian consumer discretion name to our portfolio as a play on a better than expected Xmas retail trading period. That stock was Harvey Norman (HVN) which looks cheap to us vs. its projected earnings growth. The other Australian consumer discretionary stock we own is the newly listed Baby Bunting Group (BBN), which looks a category killer to us with excellent management and growth prospects. BBN has performed very well since its IPO.
All-in-all we have increased our exposure to Australia by derivatives and specific industrials. I realise for SMSF’s it’s been a tough year with the basket of most widely held SMSF stocks hit harder than the index itself this year. The good news is I think the worst of that is over and your portfolios might get a little brighter into year end.
I am also in the Christmas spirit and have dropped my minimum investment in the AIM Global High Conviction Fund from $250,000 to $100,000 for the month of November. If you are a sophisticated investor and you want to join us for the journey please email us at la@aimfunds.com.au. The fund continues to perform well, being up around +3% since August 1st while the ASX200 is -10% and MSCI World Index -4%.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.