Market Matters Morning Report Friday 12th August 2016

Morning Report 12/08/2016

Market Matters Morning Report Friday 12th August 2016

The "Carry Trade" is back in town

Yesterday the Reserve Bank of New Zealand (RBNZ) cut interest rates 0.25% to 2% and the "Kiwi" rallied strongly, including 0.75% against the "Aussie". Similarly, the Reserve Bank of Australia (RBA) cut our rates to 1.75%, the lowest in history, earlier this month and yet the "$A" now looks destined to soon make fresh 12 months highs. The 12% appreciation in our currency during 2016 is bad news for the RBA who want a lower currency to make Australian exports more competitive on the global stage.

Technically the $A looks destined to test the 81c region which may force the RBA to cut rates again even if they prefer not to.

As a side note, we believe this an amazing time for people to pay down debt but aggressively borrowing at these levels with a variable interest rate to buy assets that are expensive feels fraught with danger.

Australian & NZ Dollars in 2016

The "carry trade" appears to have raised its head again with global investors hungrily chasing yield. Although interest rates may feel extremely low locally on the global stage, we remain relatively high compared to negative rates in Europe and Japan, plus the US still at 0.5%. The Carry Trade is defined as below:

"A carry trade is a strategy in which an investor borrows money at a low-interest rate in order to invest in an asset that is likely to provide a higher return. This strategy is very common in the foreign exchange market."

This money pouring into Australia has to go somewhere e.g. stocks and bonds. Our local 3-year bonds have been in a bull market since the 1980's and are currently trading close to all-time highs (and thus yields near all-time lows). Hence while returns are diminishing in this asset class, the safety factor continues to attract funds.

Australian 3-year bonds Quarterly Chart

However, some of this Australia bound money will / is finding its way into equities and had helped with the ASX200's 17% appreciation from the lows set earlier in 2016. While earnings will define a company's share price / performance on a longer term basis in the short term, the pure weight of money can / does push equities to very elevated levels in a bull market – which we believe this is currently unfolding.

Short term we can still see a test of 5625-5650 for the ASX200, perhaps on index options expiry next Thursday which often gives a push to the upside.

ASX200 120-minute Chart

So far in 2016 the vast majority of buying from overseas investors appears to have been focused in the resources sector with strong gains almost across the board. Interestingly the high yielding banking sector has largely been ignored with the CBA up 8.8% up from its 2016 lows compared to BHP up a mighty 44%. Remember resources were almost universally hated at Christmas as banks are today.

Our view at Market Matters has remained for over a year that the US stock market would form a blow-off style top in 2016/7 prior to a greater than 20% correction. Generally, when markets form a major top, it's the previously unpopular stocks that do the heavy lifting towards the end. The resources clearly held that mantle locally earlier in 2016 but will the pass now go to the banks?

Banks globally are having a tough time – it’s not just a localised to Australia. In the US the S&P500 made fresh all-time highs last night, but their banking sector remains 17% below the highs of 2015 – Unfortunately, this is still a better number than our banks which remain 25% below their 2015 levels.

It should be remembered that is was the chase for yield that sent our banks spiralling upwards in 2015 - i.e. our banks were driven higher in early 2015 in part by the "Carry Trade". We do not believe that will be repeated to the same degree in 2016, but we are in the minority seeing value (and upside) at current levels.

Investors who buy CBA today in the low $76 region are likely to receive over $6 in full franked dividends over the next 12 months, around 8% fully franked return. We are very aware that purely chasing stocks on a yield basis is a "mugs game" but CBA remains a quality company which is in a tough part of the cycle for banks. With the diminished likelihood of capital raisings for the banks they look relatively good value today.

Importantly, sophisticated investors can improve this yield by selling call options while adding a little downside cover - if you have any questions around this, please drop us an email.

S&P500 Banking Sector Monthly Chart

Summary

We remain short term bullish the ASX200 targeting the 5625-50 region.
We like the local banking sector short-term targeting another 5% upside minimum.

The greater the "Carry Trade" is implemented by investors, the larger the risks become in the future if we get a burst of the currently inflating "Bond Bubble". The catalyst for this will likely be a sharp rise in interest rates if inflation starts to kick in on the back of rising wages.

Overnight Market Matters Wrap

The markets in the US closed higher last night with the Dow up 118 points (+0.6%) to 18,613, while the S&P closed up 10 points (+0.5%) at 2,186.
Oil was the major catalyst once again, with Crude finishing up US$1.78 (+4.3%) to US$43.49/bbl on news that there were moves afoot to stabilise prices coming from the Saudi oil minister.
Iron Ore was weaker here in our time yesterday and finished weaker in European time, down US$1.22 (-2.0%) to US$59.36/t
The ASX 200 is expected to open stronger this morning, up 43 points, testing the 5,551 level as indicated by the September SPI Futures.

Regards,
The Market Matters Team
Level 12 28-34 O'Connell St
Sydney NSW 2000

All figures contained from sources believed to be accurate. Market Matters does not make any representation of warranty as to the accuracy of the figures and disclaims any liability resulting from any inaccuracy. Prices as at 12/08/2016. 9:00AM.

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