Peak central bank power is over, so what now?

Chief Investment Officer and founder of Aitken Investment Management
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Happy New Year to all of you. I believe it can be another positive year for investors, albeit you MUST position yourself for rising global interest rates.

I’m typing this note from the USA, and I can tell you by my observation that this economy is really humming. Waiters expect 25% tips, retail sales are strong, and Wall St is reflecting all of this. What must come next is inflation and a series of interest rate rises from the Federal Reserve. Bond investors will also demand higher yields to compensate for inflation, while the US tax cuts mean Washington needs to issue more bonds to fund higher deficits. All in all, I have to say it does feel buoyant over here, which is good for global equity investors.

Off with a bang

While Australian equities have been a standout global laggard in the first few weeks of January, with the S&P/ASX 200 marginally down 2018 year-to-date, in the rest of the world, the equity markets have started with a bang. I suspect the S&P/ASX 200’s notable underperformance has been driven by two factors:

  1. The strength of the Australian dollar, which is approaching 80 US cents and;
  2. The selling of high-yield Australian equities by global fund managers on the correct view that interest rates are going up and the relative attraction of equity dividend yield is falling. While resources and all things China facing have done well on the ASX, the weight of selling in yield stocks and offshore industrial earners has outweighed the gains in resources.

The AIM Global High Conviction Fund which I run, is experiencing a very strong performance start to 2018. While global equity markets have also started the year strongly (MSCI World US dollar up 3.85%), the fund’s combination of concentrated long positions in Hong Kong and European financial and cyclical equities, when combined with concentrated short positions in US Treasuries and bond-like equities in Australia, has generated estimated returns ahead of global benchmarks at this point of the month.

Thankfully, the fund is fully hedged to the rising Australian dollar. That is unlike most of our Australian-based global investing peers and playing a role in our strong returns. I was bullish on the Aussie dollar, and I continue to feel the Aussie will head above 80 US cents, despite interest rate differentials being in favour of the US dollar. The Aussie dollar is the “commodity currency”, and commodities are on a tear, driven by the strength of the Chinese economy.

For those who don’t know, Chinese equity markets have started the year stronger than anything (+9.1% year-to-date 2018). While this has helped my fund, as we have 35% of our money invested in Chinese equities in Hong Kong, I believe more broadly, it’s trying to tell you that the Chinese economy is going well and Chinese company profits are rising. I remain of the view that Chinese equities entering the MSCI World Equity Index this year is a monumental event and will drive flows towards China from the USA, Korea, and Australian equity markets, as relative index weightings change in favour of China.

Interest rate outlook  

I strongly believe markets are breaking in favour of our high conviction cross-asset class long/short global mandate. While the sharp equity gains of the first half of January have seen the fund take profits in selected stocks we believed had become stretched, we remain very firm in our long-held belief that interest rates have bottomed for our lifetime. We also think inflation has bottomed for our lifetime, central bank influence has peaked for our lifetime, and the only way cash rates, mortgage rates, and long bond yields can move is up.

US 10 Year Treasury Yield (1987 – 2018).  Trendline Breaking.


The fund is positioned for rising global interest rates, rising inflation and the declining influence of central banks on asset pricing (aka Peak Central Bank). While we have reduced our gross equity long from 105% to 80%, effectively raising some cash to deploy when we see opportunities, we have simultaneously increased our short bets against long bonds and bond-like equities. We believe duration is badly mispriced, due to inflation expectations being too muted and the ongoing commitment of central banks overestimated. The subsequent rise in all forms of interest rates as inflation expectations change/central banks reduce purchases, will see the record low yield (i.e. record high price) being currently paid for long-duration assets reverse.

You are simply not being paid the right coupon for the capital risk you are taking. I remain very firmly of the view that bonds and bond-like equities are not “risk-free”, rather “return-free capital risk”. There is a MUCH larger chance you lose in capital a multiple of the current yield you are receiving.

Beware the crowded trade 

We believe that capital losses will now start stacking up in bonds and bond-like equities (you can see that already in Australia with Transurban Group (TCL) -5.8%, Sydney Airport Holdings (SYD) -5%, Goodman Group (GMG) -4% year to date 2018). Volatility across all asset classes will rise from record lows as the world’s “risk-free rate”, the US 10yr bond, rises from 2.50% to 3.50%. Rotation inside equity markets will favour value/cyclicals over growth at any price and pure momentum strategies. Low P/E will outperform high P/E. It is a time to beware of the crowded trades of the last three years.

This year has already seen the Bank of Japan reduce bond purchases and the ECB hint towards early reductions of their bond buying QE program. This is hugely important. If we see the ECB and BOJ back off bond purchases, then to us that is the catalyst for yields to rise faster than markets currently expect. This will also be happening as the Federal Reserve starts to shrink its balance sheet and concurrently raise the fed funds rate another four times (+1.00% in total), and the largest holder of US debt, China, scales back purchases. The question becomes: who is the next large-scale buyer of bonds?

The Fed, BOJ, and ECB hold a combined $14 trillion of securities they have bought since 2009. That has had a monumental influence on everything from US bond yields, to Apple shares, to Sydney house prices.

This is it: the turning point in all forms of short and long-term interest rates. I am certain of it and we will continue to broaden and increase our bet against bonds, bond-like equities, over-geared businesses and over-geared consumers, and increase our bets in favour of cyclical equities but particularly financials and cyclicals with inflation hedges.

It is an exciting time for an active global fund manager. These are the moments in cycles where we can do things others can’t, due to our flexible global mandate. If we do execute our strategy well, we should be able to continue to generate returns better than benchmarks with lower volatility than those benchmarks. It is a time for active high conviction global portfolio management at the turning point of the interest rate cycle.

All in all, I wish you a happy 2018. The 2018 year has started well for AIM investors, continuing the momentum of the +21.5% return we generated in 2017.

I’m really looking forward to this year. It’s going to require vigilance, conviction and moving well ahead of the pack. However, there is money to be made, just in different ways to the last three years.

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.

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