Is it time to sell US equities and bonds?

Christopher Joye

In my AFR column I reflect on Xi Jinping's masterful manipulation of Donald Trump and why a profound change in global hedging costs could radically reduce the returns Australian investors receive when allocating to US equities and US bonds (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:

"China’s masterful new emperor, Xi Jinping, appears to be predictably playing his myopic and hedonistic US adversary, Donald Trump, like Napoleon’s Stradivarius. Xi’s silkily smooth speech this week made all the headline-grabbing concessions Trump desired with not a hint of the tit-for-tat, trade-war rhetoric that would have given markets conniptions. Xi knows that after years of hyper-accelerated development China has little to fear from a levelling of the commercial playing field, and that in the long-run healthy competition is a necessary condition for world-class productivity and entrepreneurship. He also knows that he can sign-up to a raft of commitments to sate Trump in the short-term, and stealthily “retrade” on them over time should that suit his and/or the Middle Kingdom’s interests (where these variables are now indivisible given the dissolution of term limits on the great man’s tenure). And by “time” we are talking decades, a horizon Trump’s TV and Twitter-centric brain, which relentlessly searches for instant gratification, could not possibly function on. Finally, Xi can rely on the West to preternaturally underestimate its foreign foe. Politicians and strategists have been utterly blindsided by the speed of China’s military modernisation and its surprisingly imperial ambitions over the last 20 years. During our lifetimes, it will almost certainly overtake America as the single most formidable global force, and perhaps even as a true hegemon preaching confucianism. You no longer see American aircraft carriers cruising the Taiwan strait (last sighted in 1996), and the now fully weaponised artificial islands erected in the South China Sea give emperor Xi complete control over his immediate naval domain. For the first time in 5000 years, China has a foreign military base (in Africa) with further prospects in Sri Lanka and, shockingly, Vanuatu. We are truly living in the "Asian century", and by the end of it Australia will be as much ethnically Asian as it is Anglo, which is a tremendous economic positive in the benign case devoid of global conflict. Emperor Xi’s conciliatory speech massaged markets back into a more munificent mood. Two of the opportunities this column identified previously—the major banks’ non-bail-in-able senior-ranking floating-rate notes (FRNs) and their ASX listed hybrids—which respectively rank near the top and bottom of their capital structures, have experienced spectacular rebounds. The bid for 5 year major bank senior FRNs has compressed sharply from 100 basis points over bank bills back to around 85 basis points, which has furnished handsome capital gains. The hybrid market’s recovery has been just as impressive. In total return terms, the ASX Hybrids Index has jumped 0.82 per cent (82 basis points) since, and inclusive of, March 29. The spread paid on 5 year major bank hybrids above the bank bill rate had blown-out from 300 basis points in January to as wide as 391 basis points on April 3. It has since contracted 25 basis points, powering the aforementioned price appreciation, with 5 year major bank hybrid spreads now sitting at 367 basis points. At current levels, major bank hybrids are paying cash yields before franking credits of up to 4.6 per cent annually (eg, CBAPD), which is higher than the 4.4 per cent unfranked dividend yield on stocks in the ASX200 index. Inclusive of franking, it is easy to earn hybrid yields of 6 per cent to 6.3 per cent, which is likewise above the ASX200’s 5.85 per cent franked yield. What about relative risks? Since 2012 the ASX Hybrid Index’s annual return volatility has been about 2 per cent, roughly one-sixth the ASX200 Index’s 12.2 per cent volatility. Another way to think about risk is through worst-case draw-downs. During the global financial crisis the ASX Hybrid Index fell 27 per cent, almost half the 48 per cent loss suffered by the wider sharemarket. During the week the credit rating agency Moody’s warned that “home loan arrears will increase” as the housing market slows down. This column has highlighted RBA data showing that mortgage default rates have been steadily climbing, which could be amplified by any out-of-cycle rate hikes as result of a recent 25 basis point spike in the banks’ short-term funding costs. Combined with the fact that house prices continue to fall—Sydney prices have now slumped more than 4 per cent while national prices are off 2 per cent from their 2017 peaks—this clouds the outlook for residential mortgage-backed securities (RMBS). Having held AAA rated RMBS since 2012, we sold out of the sector a few months ago and have observed some offshore investors doing the same with over $1 billion of RMBS portfolio sales hitting the secondary market since February. (Many offshore investors are also buying.) The lower-ranking tranches in these bonds are automatically downgraded by Standard & Poor’s if house prices fall 10 per cent or more, and we are already one-fifth of the way based on the latest CoreLogic index data. One important game changer for global markets has been a radical shift in hedging costs that means overseas investors in US shares and bonds have to pay to hedge these assets back into their local currencies rather than receiving returns (with no cost at all) from doing so, which has been the case for Australians over the last two decades. CBA’s currency strategist Richard Grace explained in a report that “the recent movement Australian interest rates below US rates as far out as ten‑years duration has meant that Australian offshore investors are now, for the first time since the early 2000s, facing a financial net cost of hedging, as opposed to a financial net benefit, of up to 4.0 per cent”. Since most Australian investors in US fixed-income and equities are hedged back into Australian dollars, the dramatic jump in hedging costs could radically reduce future returns. CBA’s research demonstrates that unhedged offshore government bonds returned only 3.3 per cent annually between 1999 and 2018. Yet hedging these assets into Aussie dollars boosted their return from 3.3 per cent to 7.2 per cent annually, notably above the 6.0 per cent annual return delivered by our own government bonds. This was because investors were paid up to 4 per cent annually in extra returns to hedge their US dollar exposures back into Aussie dollars. For the first time since 2000, these hedges will detract from, rather than adding to, returns, which could fundamentally shift the local asset-allocation calculus. Investment banks have been talking about how this is already affecting decisions with widespread reports of Japanese institutions selling US bonds to buy European credit, which now offers positive, rather than negative, returns via hedging. This is also true for many offshore investors into Australian equities and fixed-income, which will become more attractive than US shares and bonds on pure hedging grounds. Crucially, this hedging dynamic will likely persist for as long as the US Federal Reserve is hiking interest rates while the RBA is not. Indeed, it has manifest on the RBA's own balance-sheet, with our central bank holding almost $30 billion of hedged Japanese government bonds because of the attractive yield pick-up it can capture from doing so." Read the rest of the article here.

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Christopher Joye

Christopher Joye is Co-Chief Investment Officer of Coolabah Capital Investments, which is a leading active credit manager that runs over $2.2 billion in short-term fixed-income strategies. He is also a Contributing Editor with The AFR.

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