Jamieson: We're starting to run into issues that can break markets

When markets are heady, it’s hard not to check your portfolio regularly. Each login and click of the ‘portfolio’ tab on your platform offer the promise of splashes of green ink, a rising portfolio balance, and a (perhaps unjustified) heightened sense of self-worth. 

'I AM a great investor and all my decisions have been wonderful', we tell ourselves. 

Equally, when markets tank, the button on the left-hand side of our mouse gets a rest. We’re not clicking that login button quite so much, we’re looking at our portfolio less frequently, and we’re – to some extent at least – sticking our head in the sand and telling ourselves everything will be OK.

While things will be ‘OK’ – the world will keep spinning - I think we would all agree that this is not the best way to approach markets during times of heightened volatility. It is precisely at these moments that we need to stay focused and arm ourselves with all the necessary information, to be aware of the risks and capitalise on the opportunities unfolding.

Charlie Jamieson , co-founder and Chief Investment Officer at Jamieson Coote Bonds, shares this view. He joined me recently for a conversation about the changing face of markets. Charlie has a masterful understanding of the macroeconomic picture, strong theses on what to do regardless of which way markets break, and an overarching sense of calm. 

And whilst Charlie readily admits that government bonds are usually the ‘boring’ part of the market, right now they are anything but.  

“Government bonds, interest rates and monetary policy are really the locomotive on the front of a big asset train. Where they go, invariably other things will be dragged.”

It is this insight, along with Charlie’s breadth and depth of knowledge, that makes this one of the most important interviews you will watch this year. 

TOPICS DISCUSSED

• 0:42 - Why government bonds?
• 3:19 - How Jamieson Coote are viewing markets and positioning for them
• 10:30 - Australia versus the rest of the world
• 16:27 - Where is the conviction at the moment?
• 25:08 - The biggest risks in markets right now

To access the interview please click on the player or read an edited transcript below.

Edited Transcript

Chris Conway: 

Hello and welcome to Livewire Markets. My name is Chris Conway. Today I'm joined by Charlie Jamieson from Jamieson Coote Bonds. 

Charlie is the co-founder of Jamieson Coote and he's a seasoned bond trader and investor, having traded bonds all around the world, from New York to London, Tokyo to Sydney, and everywhere in between. I'm incredibly excited to be talking to him today because I think he's going to offer some very powerful insights into what is happening in markets right now. So without further ado, Charlie, welcome.

Charlie Jamieson: 

Thank you.

Let's dive in because there is plenty to cover, but we'll start with the question of; why only government bonds? Why is Jamieson Coote only looking at government bonds?

Yeah, government bonds are a bit of a niche, in the fixed-income markets. Australia's been in structural deficit since the GFC and the fixed income silo as a product has really bifurcated out a number of different times. and there are a lot of different offerings within that. 

That gives us as allocators a lot of choice depending on where we are in the cycle. Obviously, the really powerful one that's had a lot of growth has been private debt. On the other hand, there haven't been too many folks focused on government bonds, which are normally 'boring'. 

Government bonds aren't so boring at the moment as they tend to be leading a lot of things with regard to the way that central banks are trying to fight inflationary pressures.

But we really wanted to focus on government bonds for their liquidity and their safety. At the end of the day, if you do buy a government bond and put it in the bottom drawer, it is a commitment, a legally binding contract between yourself and the government. Governments don't die. Corporations sometimes do. 

Sometimes we may wish governments would die, but they don't and their bonds are very high-quality assets through time. Now they are volatile, more volatile than they have been at the moment. But of course, if you were to buy bonds and ladder them, then they have no volatility, as you get an income and you get your principal back at the end. This makes bonds a wonderful portfolio diversifier.

As much as everything is having a very difficult this year, government bonds included, they do still have a role to play in portfolios and they will lead a lot of other markets. Bond rates provide our discount and funding rates for everything from fixed income, and property to equities and the like.

So it's very important to watch what's occurring there. They have big linkages through into the foreign exchange markets, but we really wanted to just specialise in that one particular piece. We saw this area as an opportunity that not a lot of the folks were focused on and that was a decision that we made many years ago and here we are. 

So I think that with the return of income and yields, certainly for now, as we're fighting this inflation monster, the product is looking incredibly attractive and hasn't really had incomes of this magnitude for a long, long time. So as a standalone asset rather than as a part of a broader diversified portfolio, they probably make a lot of sense for folks from here on.

Charlie, you touched on it there earlier. It has been a tumultuous year for bonds. We've seen yields spike probably the most aggressively that they have since the early nineties. More recently, we've seen a bear market rally. What has that meant for how you position your portfolio?

Yeah, it's been very volatile and obviously there've been some things that have been a little bit unforeseeable. I guess the reversal of the yield curve control policy got things going in Australia. That was very much against the communications that the central bank had delivered to folks prior to that. 

But really this year has been about dealing with the over-stimulus of economies. Biden had a number of goes fiscally. The Fed has left monetary policy settings, too easy for too long, and then the whole thing's been turbocharged by the war in Ukraine and put a lot of pressure on energy markets and global food markets and the like. 

It's all crescendoed into this horrible inflation outcome which has required utilising the very blunt tool of monetary policy to try and curtail demand. And essentially we're trying to take away a lot of the wealth that people have generated over the last few years in order to calm down their consumption and demand habits.

That's all against a backdrop of supply, which is constrained certainly in the energy space, with no CapEx investment over the last few years as people have been told again and again that we'll be moving away from carbon and into a more green future. But we're not all the way there yet. And so, now that there are restricted supplies in some of these carbon areas in the economy, then clearly energy is going to be a huge issue and such a big driver of the inflationary story.

So from our point of view, we had a very chaotic sell-off into the middle of the year. I think equities finally really joined in at that time. 

We've been reminding folks that government bonds and interest rates and monetary policy are really the locomotives on the front of a big asset train, and where they go invariably other things will be dragged. 

Now there'll be time lags in that. Obviously, for some things like unlisted assets and these types of things, they haven't even been marked to market yet. But if you are looking at publicly and liquid traded markets that are down anywhere from 10 to 30 or 40%, you can assume that the private stuff is there or thereabouts, if not more, under some kind of duress if it does need to be moved quickly.

So I guess, we felt that we would have that rally coming out of the summer period as you alluded to. So I think the bond market made its highs for the year, about the middle or towards the end of June. 

The problem is that equity markets have become so trained to follow these types of movements in the bond market, and this pivot that we're all looking for from the Federal Reserve, that they had a really powerful rally as well. In doing so, they actually eased financial conditions, which is absolutely what the Federal Reserve does not want to see, and so they were tremendously hawkish coming out of Jackson Hole at the end of August. 

So here we find ourselves in the early days of October now where again, equities are on the back foot. Government bond markets have sold off in expectation of more hikes required to break the back of the inflation monster. That should and is occurring, we believe with oil being that swing factor that can ultimately control how quickly that might come down.

But lots of things in the inflation story are now decelerating and that's good news. Certainly in goods, that's been happening for a little while. Service is a little bit sticky. Energy's been coming down. Look, that's been a lot to do with the release of Strategic Petroleum Reserve oil by Biden. And I guess the Saudis and OPEC have torpedoed him a little bit in the last few days. So that's all in front of us that we've still got to deal with.

But if we look around at where things might end up, the markets are suggesting that we hit the peak Federal Reserve funds rate, which is really driving everything globally, between March and June of next year. That all seems fine and plausible and has a glide path toward that place. 

The problem is that we're starting to run into issues that can break the markets, and we've seen that in the UK with some horrific moves in UK asset prices, both bonds, currency and equities. And we are getting to the point in the cycle now where we're probably moving on from really being primarily worried about inflation. 

Obviously, it's still absolutely critical, but we are transitioning across to more of a liquidity and credit issue, as people are being asked to refinance their existing obligations at these catastrophically high-interest rates versus what they've been used to.

And certainly, anybody that did gorge on debt through the last few years, is in for one hell of a surprise when they come to refinance, in terms of the rates that they're asked to pay. But it's really more of the confidence of the markets in rolling those folks forward. So the really obvious example to use a good one of recent times is the eurozone sovereign credit crisis where at some stage, some of the weaker and peripheral eurozone countries owe an awful lot of money, and the core is not prepared to roll them forward or the markets are not prepared to roll them forward, and we'd like to be repaid on Monday as well. 

That causes an incredible bottleneck in the system. And so that's what we're potentially up against. Obviously, in the UK it's been the story about requiring margin for fast-moving asset prices and not being able to easily provide that.

And so this is all ahead of us, and I think that sadly, this is the next phase of what we've got to go through. So we're moving our portfolios to be really, really liquid, to be really clean in the expectation that people might need to utilise us in exactly what we're there for. 

It's one of the downsides of running a fund, but on the bad days, people clearly want their bond monies back. We are liquid and they can move very quickly and they can move to deeply discounted growth assets or whatever that might be on that day. 

It happened to us pretty aggressively in COVID and that's absolutely correct. It was very good for investors at that time, very not great for the fund manager, but we had huge redemptions and that was completely correct. Bonds were trading at a premium at that time. Obviously, everything else was deeply discounted in March 2020.

Once the policy settings were moved to a position where everything would be very well supported, where everybody knows the story thereafter, equity markets absolutely took off. Credit spreads absolutely came ratcheting tighter and people made a lot of money moving out of government bonds and into those discounted and depressed asset valuations at that time. 

So we're getting really liquid and probably that's the big change that we've made in our positioning, in the expectation that we could have one of those moments coming up sadly. And that's something that everybody needs to think about and have a game plan as to how they're going to navigate.

Charlie, you've touched on a few different geographies there. I really wanted to ask about the messages being passed from the Australian bond market versus the global bond market. Typically Australia over recent cycles has performed better than the global economy. Are you seeing that again? What are some of the messages that are coming out of the Australian bond market?

Yeah, so Australian bonds have had a really big outperformance versus particularly US bonds of late. That's an acknowledgment that the RBA just simply can't move at the same rate as the Federal Reserve, nor does it need to. We don't have the same issues that the American economy is facing. 

That primarily stems from the fact that we didn't fire everybody in COVID. Everybody got JobKeeper and then moved back into those existing roles. So we don't have that push, unlike the American system where people were literally made redundant or moved on and then needed to reapply and there was a war for talent. So we're not facing that kind of CPI pressure that the US economy has faced.

But the big issue here has been that Australia has a very high transmission mechanism with regard to its monetary policy in terms of a lot of people still on variable rate mortgages, and as rates are ratcheted higher as they have been, 250 basis points to 2.6% now, that is still yet to flow through the system, but it will flow very, very quickly.

In the United States, people are much more reliant on long-dated fixed mortgages. So if you were lucky enough to have a 30-year mortgage at 3%, if rates go to six or seven, I'm all set at 3% for 30 years. What do I care? It doesn't change your cash flows tremendously in the same way. So it's a much shallower transmission mechanism. And we've argued for some time, that Australia wouldn't be able to hike to the same degree as others. But having said that, if others do continue to hike, Australia will get dragged along in some kind of acknowledgment. And that's mainly to protect the currency in some way, shape, or form.

So the Australian bond market's actually done pretty well. Obviously, it had some very wobbly times around the release of and reversal of yield curve control, that really wrong-footed the bond market. 

Sadly, a lot of international investors left at that time, and I don't think they'll come back quickly. They don't see the RBA as being a highly credible central bank in terms of the way they've communicated. All central banks have got their forward guidance wrong and they've all realised that having a singular view of the way the world might play out in such a tumultuous time as we're faced with, is a bit nuts. So they need more flexibility with regard to that and that's probably a good thing. I think forward guidance was necessary coming out of the GFC and the like, but it's probably a bit over its use-by date.

Clearly, we're in a very uncertain world. We're facing a lot of geopolitical disruptions, and a lot of the low volatility and the certainty that we enjoyed, particularly post the GFC, has been thrown into material upheaval by COVID, and then the onset of some of these flareups, Russia, Ukraine, or will it be Taiwan or whatever else it might be.

So yeah, we're seeing that the Aussie bond market is following along with other bond markets, but certainly outperforming now, which we have expected for some time. We are back to levels where from a go-forward point of view, if we look at the market in a series of scenario analysis kind of outcomes, assuming let's say we've got five, the really low probability, but possible tails are peaceful resolution in Russia, Ukraine. 

Everything can calm down. Global energy is made available again, prices fall, and speculators are washed out. That's the best outcome. And obviously, that means that inflation heals faster and central banks have got less to do. Great result for asset owners. While in that scenario, clearly, bonds would do very well because there'd be a lot less to do, all the way through to war with Taiwan, horribly high energy prices, and continuation of inflation.

And over those kinds of scenarios, if you look at the mathematical returns of bond markets, assuming we'd get to 5%, 10-year yields or thereabouts, which is a hundred basis points higher than where we are today, all the way through to say 3%, so a hundred basis points lower, then the expected returns over time are between negative two to plus 10 for government bonds. 

And so we probably argue that in a scenario that's the negative two, other asset classes would be obliterated. And so again, it hasn't been a great place to be because it's a negative number, but relative to other asset classes, you'd probably be doing really well, and then have a lot of firepower to rotate into deeply discounted assets. If we were to hold interest rates a hundred basis points higher than today, I think having everybody felt that the power of rate moves over this year and what that's done to equity markets, extrapolate that again and clearly, we would be facing a series of credit issues, delinquencies, solvency. So we would have to expect that asset values would be lower.

So yeah, we're thinking about it in that regard, and certainly, as I said, as a standalone asset class, it's pretty appealing. They're the extremes. Obviously, the central scenarios are far more mute than that somewhere in the 2, 4, 6 kind of range, depending on how we look at that. We've released a bit of work on the way that we think about those scenarios. 

Obviously, the middle scenario is that we do enter a slowdown that probably emanates out of Europe, which is the obvious place, that takes the global economies towards recession. We're technically in a recession in the United States at the moment. Australia is starting from a rude position of health, so it might take a little longer, but obviously, we're not impervious to those other moves that will occur globally.

Charlie, I want to zoom in on the portfolio a little bit. We've talked a lot about the macro. Where is your highest conviction at the moment and can you give us some insight into how the portfolio has changed over duration, quality, and yields recently?

So obviously as we said, we've moved to a much more liquid portfolio in that we have very liquid products that we manage, but we can manage other things like state government bonds or supernational bonds. 

Supernationals are things like the World Bank or the European Investment Bank. They're actually collateralized and guaranteed by multiple sovereigns. But we've moved away from them because they're not as liquid as pure government bonds. And in particular, we've moved away from European Investment Bank bonds whilst there's obviously a war on the eastern flank of Europe. And the reason being is that that vehicle has been touted as a recapitalization vehicle in other European crises, most particularly in the eurozone sovereign crisis. If that would occur then the values of those bonds would change very, very rapidly. And we don't want to be near anything like that, given the uncertainty that is obviously at play there.

Look, we really like duration over the medium term. I think it's reset to a point now where it can really be very additive to a portfolio. As we said, even if it does sell off from here, the vast majority of the total return damage is now complete. And the assumption is that if it did sell off from here, it would be because inflation has remained stickier, and then central banks are credible in their inflation fight and they raise rates in order to kill the economy, killing inflation in the process. 

So there's a limitation to how far long-dated bonds would probably go in that scenario, whereas very short-dated bonds could continue to rise. But they don't play a big part in the total return story.

So as we said, if we moved the 10-year bond yield in Australia under our assumptions from four, well we did the maths at the end of the third quarter, I think we closed at 3.89%. If we moved it all the way to five, it's about 111 basis points further. The total return through 12 months would be negative 2.23 from memory, I think. Better check that exactly. 

Whereas if we had an 89 basis point rally down to 3%, so not exactly symmetrical, the total return is 9.99. I can remember that one. It's a bit of an odd one. I was hoping it'd be 10, just because it makes the market index look that much more exciting.

So we're at that point where there's a big shock absorber in those types of instruments. We have seen in the UK, those things can be moving very quickly under a solvency-type issue. Then people sell what they have in order to raise cash and that could be government bonds. So we need to think through those moments. But unless you're a speculator, I think as an investor then they've got a very credible role to play. So we do like duration and obviously, we want to be very liquid, very high quality.

We still think that everything that is spread-based, and obviously that's driven primarily by corporate credits, has more to go, and those spreads have extended. That's a very natural extension. That is a function of the risk-free rate that they sit above. 

So, if I give you a really simple example. 

If we have a 5% yielding government bond, say, and a BHP bond, which is at five and a half, well then there's a 10% credit premia for the difference in credit quality between the government, which can always tax its citizens and won't die, versus a corporate that could die in the wrong set of circumstances. And there are lots of corporates that have died over time.

If the government bond then rallies down to 1%, the difference between the two doesn't stay at 50 basis points or half a percent, it tends to tighten as that spread, or that credit premia is readjusted and obviously there's a big hunt for yield. 

So you can see the way that that spread would compress and that's absolutely what's occurred over the last little while.

This also works in reverse. When we really extend the risk-free rate and those government bond yields jump higher, then those spreads need to expand to reflect that credit risk again. And obviously, they also expand in the expectation that that could be a little harder for some folks to refinance. And it's these credit blockages that we've seen. 

We had it briefly at the start of 2020 in COVID, but then central banks cleared the pipes. We had it at the end of 2018 at the end of our last hiking cycle where the Fed only got to two and a half percent before credit markets fell over. We're well beyond that today, but we've got there much faster. 

So this is maybe the eye of the storm moment and we'll be talking about this a lot more next year.

There is concern that the weaker names in those corporate environments, thinking about high-yield issuers, that might have been in growth-heavy industries. In Australia, we don't need to worry, I don't think, but in the US and in Europe in particular. 

It's death by association in these markets. If there are problems there where there are lack of confidence moments, people cannot be refinanced, essentially they are taken to insolvency overnight by the lack of ability to get through the debt capital markets system. 

Then everybody stands back and says, "Wow, gee, XYZ just didn't make it. I don't want to be anywhere near ABC." And you do get this systemic issue. And that's generally where central banks have needed to do something to come in and lower the volatilities and provide more certainty.

So I think that's something that investors still need to think through because clearly, that corporate credit space is the really important lubrication of the whole system. 

If those folks can't fund themselves, and there are a lot of zombie corporations that clearly can't satisfy their debt obligations and are reliant upon debt capital markets to continuously finance themselves. 

If they start going down, then obviously they drag equity indexes with them. And that's absolutely what we saw at the end of 2018.

So you had a really pronounced rise in interest rates in terms of government bond yields. You had essentially a seizure of high-yield markets in November of 2018. There was no debt capital markets issuance for the month of November globally. And in December equity markets were down 15, 20% almost vertical. 

That caused the Fed to pivot at that time. They went from, the initial comment they'd made in October of that year, "we're a long way from neutral and we're likely to exceed it". And that was at two and a half percent, and the market expected that they would ratchet on well beyond that. 

That was in October, as I said. By the 4th of January, Powell essentially stood up, put both his hands in the air and apologised profusely, and said, "We will be patient from here on." Which was the pause until July 2019 when Trump essentially forced them to cut interest rates ahead of COVID.

So that's a moment that we think is coming up in the fourth quarter, if not the first quarter. The market's expectation in terms of when the Fed might finally get to their terminal rate, as I said, is between March and June, looking at the way the inflation profile starts to fall away. That should mechanically occur. 

I mean obviously, inflation is a rate of change concept. And so we've talked about this all year that if things are accelerating in price, then it's very inflationary. If they just a flat line, inflation goes to zero. Over time, it just literally goes to zero. And we don't live in that world, I don't think.

But you're seeing that the most obvious one for folks every week is filling up their car with petrol. Petrol prices are broadly stabilised. They still fluctuate, but there isn't that acceleration like we've seen previously. 

In Australia, we've had issues with very wet weather and floods and crops and those types of things. I remember paying $15 for a punnet of strawberries for my little guy, who loves strawberries in the morning, thinking this is going to kill me. They're back to $5-6 a punnet or something like that.

So it's that rate of change that really matters. And because the rate of change has been so violent leading into this phase over the last 12 months, if things just calm down and moderate considerably, then inflation does start to fall away. So the expectation, as I said from March to June of next year is that inflation's somewhere in that 3-4% area coming from nine in the United States. 

Clearly once that is occurring, then the Federal Reserve can pause and let the lag effect of their monetary tightening wash into the economy and that should complete that reset and recalibration back to a more sustainable long-run average.

Charlie, aside from the $15 strawberries, what's the biggest worry for the portfolio? Is it that default risk and contagion you were just describing? Is that the thing that probably keeps you up at night most often?

I actually think that's mechanical. It must occur. You can't take the biggest debt burdens that we've ever seen, ratchet interest rates higher, and expect that everybody is okay with that and there are no failures. 

So I think we're coming into a period where there is real default risk in markets that we really haven't seen ex the GFC for the last 20-odd years, where the declining long-term interest rates have been very supportive and this kind of central bank put where they immediately paper over any kind of crack in the wall. 

They can't do that this time because they can't risk re-accelerating inflation, which means there does need to be a little bit more pain. So yeah, I think that's the biggest thing that we do worry about.

I guess we're watching the energy situation very closely as all folks should be, because that is a big calibrator of how quickly inflation can fall and therefore how much longer we need to stay in these settings that are restrictive. 

I mean, they are absolutely supposed to cause pain. This is what is supposed to occur by these policies. It's supposed to be uncomfortable. And the whole idea is that you and I stop buying stuff and we take the pressure off what is clearly a restricted supply environment.

Look, a lot of the supply issues that we faced coming out of COVID have normalised. But the really obvious one in Australia and in a lot of other places has been global energy and then global mobility in the supply of labour. 

Here we generally have 250,000 folks net migrate every year. That's starting to occur again, which is good. And we normally have about 300,000 international students. We haven't had either of those things. And so the labour market has been very tight. 

Those things are normalising but clearly, dampening the demand channel aggressively will allow them to find equilibrium a lot faster than would've otherwise occurred.

Thanks Charlie. Well, ladies and gentlemen, I promised you some very powerful insights and Charlie has delivered in spades. If you enjoyed that video as much as I did, make sure to give it a like. And of course, don't forget to subscribe to our YouTube channel because we're adding great new content every week.