I strongly advise you that you need to position yourself mentally for a period of increased volatility in global and Australian equities.
The days of buying every trading dip and smooth upward sailing in equity indices are coming to an end as the Federal Reserve comes to an end of its Quantitative Easing (QE) program and starts the process of US interest rate normalisation.
You can see this already occurring in Australian equities, with the ASX200 basically flat for 2014 year-to-date and down 10% in US dollar terms for September alone, led down by the heavyweight banks.
Australian investors are caught in the middle of some major global shifts, led by currency.
The currency trade
As I have written all year, I am a major US dollar bull but being a major US dollar bull has other negative ramifications.
In the chart below, you can see the broad US dollar Index (DXY) has taken off like the space shuttle in the last three months.
This is because the Federal Reserve is ending the US dollar rights issue known as QE, the FED’s balance sheet is peaking in size, and the FED will raise cash rates before anyone else, narrowing interest rate spread differentials.
Obviously, anything denominated in US dollars has been under heavy pressure on the other side of this US dollar resurgence. The Australian dollar, Euro, Yen, gold, copper, iron ore, oil, you name it, has tanked inverse to the US dollar.
This makes perfect sense and will continue, as US investors repatriate to US dollars from all forms of multi-year carry trades.
Unfortunately, we are all part of the carry trade. The Australian dollar and high yield Australian equities were a very big part of the short US dollar carry trade that is now unwinding. If you have been wondering why your bank shares have been falling, it’s as simple as the carry trade being unwound.
To illustrate this point, here are the last 30 trading days in the Aussie dollar/US dollar and the ASX200 Financials Index (XFJ) which are dominated by the big four banks.
The Aussie dollar and the banks have basically been joined at the hip this month, which confirms carry trade unwinding by global investors.
This, of course, begs the question: when does it stop? It stops when the Aussie dollar stops falling, which isn’t anything the Aussie dollar can control. It stops when the US dollar stops rallying and I don’t think that is any time soon.
US dollar to regain title
Yes, there will be the odd day of trading bounces, but, to me, it is blatantly clear that the US dollar is moving back to regain its title as the world’s reserve currency. I think this is a genuine trend change in the US dollar and inverse in anything effectively priced in US dollars.
Similarly, with the RBA/APRA starting to rattle the macro-prudential intervention sabre in terms of investment property mortgage lending, analysts and strategists will start looking at revising downward credit growth forecasts.
There is a scenario building, where Australian mortgage banks face macro-prudential lending limits, increased capital requirements and rising wholesale funding costs, all of which will lead to consensus bank sector EPS and, dare I say it, mild DPS forecast downgrades.
CBA is our biggest bank and biggest index weight (9.32% of ASX200). To me, this chart is a classic trend change chart. It doesn’t mean the share price will collapse, but I suspect the next level of support in the lower to mid $70s will be tested and any rallies will be sold into. Beside the CBA chart is the ASX 200 Financials Index (XFJ), of which, of course, CBA is the largest weighting (20.7%).
My clear point is that macro, micro and technical forces are all working against Australian banks right now and I don’t see that changing. Sure, there will be the odd trading bounce day, but I remain underweight the sector and again remind readers of the clear near-term correlation of the sector to the Australian dollar. This Aussie dollar correlation makes perfect sense. Australia is 2% of global equity markets and far from a “must own” for global investors, particularly as our heavyweight financials are globally expensive to those who can’t value franking credits. The currency falling gives them the excuse to be zero-weight. It’s an asset allocation play.
The other point I want to stress is: who will be the marginal buyer of Australian yield into a correction? It won’t be foreigners. They are selling with the currency falling. It has to be Australians, who can value the franking credits. To my assessment, however, Australians have the “house full” sign up when it comes to yield allocation.
You can see the recent currency driven selling of Australian banks, for example, has run into very little buying resistance. It’s been like watching a hot knife through butter, as the carry trade world gets carried off. Ditto the Australian dollar itself, which is struggling to yet find a natural buyer to take on all the carry trade unwinders.
It’s worth noting that from the peak, Australian banks have lost double their prospective dividend yields in capital losses and triple in US dollar terms.
Prospective does not put a floor under price when there is a major, multi-year trend change, like we are witnessing right now. In fact, there’s every chance of a downside over-shoot here in the Aussie dollar and Australian yield equities, as the world presses the sell button and the SMSF world decides it owns enough yield already. The chart below overlays the ASX Financials Index (XFJ) and the AUD/USD cross rate, showing if the correlation holds, which it will, Australian financials (green line) have further to fall (another -5%) in capital terms.
It’s only when it starts unwinding do you realise how crowded a trade it was. I think we are all underestimating just how big the short US dollar carry trade has been and how big, in effect, the personal carry trade into yield equities/hybrids has been. That’s why this could all overshoot on the downside, as everyone rushes for the exit.
What’s going on?
My note today is more trying to explain what is happening and that it could easily continue. As I wrote last week, if you are happy collecting fully franked dividends, ignore me. If you are also interested in capital preservation, then be aware that further capital losses could be ahead. At best, expect increased volatility.
After 20+ years of market experience, I can tell you I do not like what I am seeing on the screens in front of me. I fear further capital losses in Australian yield equities and I fear just about nobody, particularly in Australian private investor land, is properly positioned for what potentially comes next.
This is a major momentum change/inflection point. It’s all driven by the resurgent US dollar and its effect on everything else. As an Australian investor, if you are to successfully negotiate the next period in markets, you have to lose the myopic home bias and start to think global, act global. Not thinking local, acting local. You also need to start thinking absolute, not relative, and condition yourself for a major step up in daily trading volatility.
If you don’t like the sound of all that, the sideline is the place for you. There’s absolutely nothing wrong with locking in some of the massive capital gains of the FED inspired last few years and moving to the sidelines for a little while.
It is certainly not a time for rampant bullishness. Don’t fight the Fed. Don’t fight the tape.
100% of Charlie Aitken’s fees for writing for the Switzer Super Report are donated to The Sydney Children’s Hospital Foundation.
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.