Market Matters Morning Report Wednesday 3rd August 2016

Morning Report 03/08/2016

Market Matters Morning Report Wednesday 3rd August 2016

The RBA cuts rates to 1.5%, now what?

By now, we’re sure all subscribers know that the RBA cut interest rates yesterday to their lowest level in history - currently a global theme! We have a strong opinion on bonds / interest rates at present which is not pretty for the coming years. Market Matters believes we are currently experiencing an artificial "bond bubble" which if it pops, as opposed to deflates slowly, will be extremely ugly for assets including stocks.

The question is, do we trust central banks that allowed the GFC to occur and have failed to create meaningful economic growth for the last 8 years to let this bubble down slowly?

Subscribers often ask us to explain what bonds are, hence here goes in relevant but very simple terms:

Bonds are issued / sold by governments and companies alike to raise money, similar to how the local banks have been issuing hybrids to raise cash – although hybrids typically have more conditions in them around convertibility / payback, etc. The current distortion with interest rates is a result of central banks aggressively buying bonds in an attempt to stimulate growth, hence pushing the price of the bonds higher.

- Higher bond prices mean lower interest rates e.g. Australian 3-year bonds are trading at 98.61 which equates to 1.39% (simply minus price from 100).

Central banks have been so active with their purchase of bonds that there are now ~25% of global bonds paying a negative return, ~25% e.g. you lend the Swiss government $1000 and in 30 years they will give you back say $970, which is simply crazy!

RBA Official Cash Rate Monthly Chart

We are living in an unprecedented world concerning interest rates, as central banks fight to avoid paying the price for the GFC - Australia has (incredibly) not experienced a recession for almost 25-years. Central banks have pushed bonds to the point where we believe there is simply no risk / reward in buying bonds / betting on lower rates - a view that was recently echoed by Bill Gross who built the world's largest bond fund.

Our view also appears to be aligned with US tech companies who have raised over $100bn from issuing bonds this year - why not get the cheap money while you can. Microsoft, for instance, issued $19.75bn of bonds in a week and received bids for $50bn – that’s huge and clearly shows the level of cash on the sidelines attracted to these mediocre returns.

Investors must remain open-minded to what may materialise in the future, remember no economists were predicting negative rates 10-years ago and very few were saying buy resource stocks at Christmas, but the materials index is up ~40% year-to-date - fortunately Market Matters enjoyed a decent chunk of this advance.

ASX200 Materials Index Weekly Chart

Bonds are generally perceived to be the safest investment behind cash, hence if we experience a crash in this sector, the ripples may be closer to tidal waves which spread far and wide. Our view is that central banks are relatively close to an inflexion point with the end of their monetary policy efforts (cutting rates) and it will now be up to Governments to step up in fiscal / structural reforms - no surprise given the definition of insanity is try the same thing over and over again (8 years) and expect a different result!

This transition of approach to economic stimulus should be beneficial to banks and detrimental to companies who are purely riding the low-interest rate wave. Banks are definitely in a similar "sin bin" that resources were in around Christmas, with the local banks still ~24% below last year's highs.

European banks remain under the cosh, falling 3.4% last night, and they are now sitting 44% below their 2015 highs, making the Australian banks look good! Ironically, the best-performing banks in Europe this year are all Asia / Emerging Markets facing which is the complete opposite to a year ago – clearly illustrating how fickle sentiment can be with stocks / themes.

European Banking Index Monthly Chart

In our opinion, Mario Draghi, head of the ECB, gave a hint to what comes next when he pointed out that if bank stocks fall, then lending follows, and the lack of economic growth may get worse. It's our opinion that central bank policies over the next 6-9 months will be bank friendly, and banks are likely to enjoy a relatively strong move similar to the resources.

The main game in town for Market Matters over coming months / years will be watching the nature of the eventual unwind of the "bond bubble.” Just looking at Japanese rates over the last 30-years, clearly, illustrates the extreme position of today. A bounce back up towards 2% yield would hardly be a blip on the chart, but it would smash markets IF it happens too quickly.

Inflation is likely to be the key to rates and stocks; simply a slow increase is bullish for stocks, and a fast ascent is bearish.

Japanese 10-year bonds (JGB's) Yield Monthly Chart

Summary

We remain short term bullish stocks as central banks embark on another round of economic stimulus, but we believe the music will stop in the next ~6 months.
What remains supportive of stocks are the huge cash levels being held by both fund managers and many companies alike. e.g. China's profitable corporates are sitting on record cash levels ~US1 trillion. Last night in the US, AEG announced a $3bn stock buyback, all short-term supportive of stocks.
Importantly, we believe it's the unwinding of the bond market bubble that will lead to the +20% correction for US stocks we see on the horizon.

We are in "sell mode," looking for ideal opportunities to increase our extremely low cash position.

Overnight Market Matters Wrap

Weakness continued in the Dow, with the index falling 91 points (-0.5%) to 18,314 while the broader S&P500 closed slightly weaker, down 14 points (0.6%) to 2,157.
Oil once again appears to be the main catalyst, with Crude finishing below US$40/bbl for the first time since April this year. Crude finished down 55c (-1.4%) to US$39.51/bbl.
Iron Ore isn’t going to help the market this morning either, as it weakened 33c (-0.5%) to US$61.94/t. Look out for the interim report from RIO, after market close today.
A weaker opening is expected in the ASX 200 this morning, with the September SPI Futures indicating an open of 16 points lower, testing the 5,524 level.

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

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