The launch of the global and Australian founder strategies at the start of the December quarter coincided with a turbulent period in financial markets. Their exposure to market risk has meant that both strategies have produced substantial negative absolute returns. The Australian strategy earned a return of -12.1% while the global strategy produced a return of -13.7% in Australian dollar terms. In a relative sense, the strategies under-performed their respective benchmarks by 2.5-3%.
For the Australian strategy, the three worst performers were Pinnacle Investment Management, Lovisa and Seven Group Holdings, which all fell by no less than 35% over the quarter. The top three performers were Evolution Mining, Lycopodium and Navitas, with each rising by no less than 10%. The largest three portfolio holdings in absolute terms are Fortescue Metals (4.9%), Evolution Mining (4.6%) and Northern Star Resources (3.8%). The largest sector exposures remain non-bank financials, resources and REITs.
For the global strategy, the three worst performers were Nvidia, Burelle and Thor Industries, which all fell by at least 35%. The three strongest performers were Marketaxess Holdings, Starbucks and Dollar Tree, which all produced returns of at least 10%. The largest three portfolio holdings in absolute terms are Saputo (4.0%), Starbucks (3.5%) and Sports Direct International (3.2%). The largest sector exposures include software & computer services, general retailers and healthcare & biotech.
The turbulence in financial markets in recent months has coincided with renewed concerns around the outlook for the US economy associated with a flat or close to inverted yield curve, which is typically couched in terms of the yield to maturity on 10 year Treasury bonds minus the yield to maturity on 2 year Treasury notes. At present, 10 year Treasuries are yielding around 2.7%, only slightly higher than 2 year Treasuries (2.6%). Conventional wisdom has it that an inverted yield curve has been a reliable indicator of an imminent recession or downturn in activity. But yield curve inversion has produced (numerous) false recessionary signals.
Setting aside the yield curve’s track record in predicting recessions, the expectations hypothesis of the term structure says that implied forward rates reflect the market consensus expectations of future short interest rates, assuming that the liquidity premium is zero. An inverted or downward sloping yield curve would therefore be evidence that investors anticipate declines in interest rates, which might reflect lower inflation expectations and/or expectations of a slowdown in real activity.
The sweep of the past forty years shows that prior to the onset of the financial crisis, the US yield curve was either inverted or flat for prolonged episodes (see chart below). The 10 year bond yield was comparable to the 2 year note yield from 1977 to 1990 and again from 1995 to 2000. During these periods, there were both strong expansions and recessions, which undermines the predictive power of a flat or inverted yield curve. Prior to the financial crisis, the only two episodes where the yield curve steepened considerably were 2001 to end of 2004 and 1991 to the start of 1995. During these episodes, the real action was in declines in the 2 year treasury note yield, which is clear because of the log scale used.
The sharp yield curve steepening following the onset of the financial crisis might turn out to be anomalous. Whether the yield curve is positive, flat or negative is probably a poor guide to the US growth outlook or the stance of monetary policy. Market monetarists caution against using interest rates to assess the stance of monetary policy and suggest that the nominal GDP outlook is a far better measure.
In the absence of a liquid nominal GDP futures market, we believe that the equity risk premium represents a better measure than the yield curve for assessing the policy stance because it reflects the corporate sector’s animal spirits. A lower risk premium, other things equal, ought to be associated with a lower cost of capital and a lift in investment spending. The cost of capital or discount rate is an important channel through which monetary policy can affect the outlook for nominal GDP. A low risk premium ought to reflect loose policy and a high risk premium equates to tight monetary conditions.
The chart below depicts our measure of the implied risk premium for the S&P500 since the early 2000s. It is noteworthy that the risk premium started to lift significantly just before the onset of the crisis, which is consistent with the market monetarist view that tight policy contributed to the financial crisis. More recently, the equity risk premium declined significantly from around November 2016 which coincides with the election of Mr Donald Trump. It is reasonable to think that the market’s expectations of nominal GDP went up due to prospects of structural and tax reforms, as well as budget stimulus.
The chart shows that the market turbulence over the December quarter has been associated with a sharp and renewed lift in the risk premium to its highest level in over two years. Investors typically look to communications from the Federal Reserve as a guide to the outlook for interest rates. But we believe there is a feedback loop. The Federal Reserve might be interpreting the lift in the equity risk premium as a signal that a more patient approach to lifting the federal funds is warranted, which appears to be consistent with recent communications from Chairman Jerome Powell and Vice Chairman Richard Clarida.
Our measure of the implied measure of the equity risk premium for the ASX200 suggests that the policy stance in Australia is at its tightest level in six years (see chart below). The shifting risk premium through time lines up well with macroeconomic developments. The lift in commodity prices in 2016 and 2017 was associated with a decline in the risk premium, which started to reverse from the start of 2018, probably thanks to a tightening of bank lending criteria during the Hayne Royal Commission. The current high level of the risk premium in Australia gives the Reserve Bank plenty of scope to be patient if the next move in the official cash rate is to be up.
Despite still growing risks surrounding global trade disputes and growing evidence of a slowdown in China, the near-term outlook for market volatility hinges on central bank communications. If the Federal Reserve and other central banks interpret the recent sharp lift in the equity risk premium as a signal that investors believe the policy stance is getting too tight thus warranting a patient approach to lifting policy rates, we would expect financial market volatility to subside in the near term.