The Jupiter Global Fund - Jupiter Asset Management

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Jupiter Strategic Total Return
■■Jupiter Strategic Total Return Review of Portfolio as at 30 September 2012 (continued)
Policy Review continued
Central banks have created a world of zero interest rates and then
indulged in massive purchases of government bonds. By the summer
of 2012, the Bank of England owned about half of the free float of UK
gilts with a maturity over three years. Most gilts offered negative real
returns. We were short as the downside risks dominated, while the
upside depended on prospects for further quantitative easing, to which
there is a natural limit. We were also short in some eurozone sovereign
debt, although this was costly to performance for much longer than we
expected as we underestimated the positive impact of the LTRO.
Besides lowering interest rates, central bank asset purchases are
intended to nudge investors into risk assets by inducing a rebalancing
of portfolios. Often, they chose risk assets that lay outside of the home
country of the central bank. Like a shoal of fish that suddenly switches
direction, this global capital moved from ‘safe’ havens to risk assets
and back causing sizable price distortions which themselves had
knock-on effects.
For example, capital flows into Switzerland pushed the franc to levels
that hurt its exporters and threatened to push the country into
recession. Switzerland’s move to peg its currency against the euro led
the Swiss National Bank to sell francs and buy German, Dutch,
French, Finnish and Australian bonds.
Zero interest rates also influenced the carry trade. Once it was the yen
that was borrowed to fund higher yielding assets. Zero interest rates
have widened the number of currencies to borrow against while
reducing the number with attractive yields.
Australia, whose dollar yielded 4.25% at the start of 2012, has been a
prime target for the carry trade with some 80% of the government
bond market being owned by foreigners. We believed that this together
with tight monetary policy had driven the currency to over valuation. In
our view, the consensus expectations for strong growth in demand for
the country’s natural resources was overly optimistic given the decline
in China’s demand for raw materials. Thus, we positioned the Fund to
be long Australian bonds (where we expected a rate cut) and short the
Australian dollar. Even a board member of the Reserve Bank of
Australia said ‘there’s too much froth in the Australian currency’. We
later took profits from our long position in the bonds after they reached
our target. The Fund also gained from its dollar short (the RBA cut
rates to 3.75% in April) and, although the carry trade continues, we
have maintained the short.
Confidence matters. Whether or not a country can maintain access to
the bond markets in order to roll-over its debts depends on how
confident bond markets are that a county is willing and able to pay its
debts with a currency that has a value that can be maintained. In the
US, signs of moderate economic growth together with signs of
stabilisation in the housing market led us to be long of the dollar.
In Japan, the trade balance moved into deficit for the first time in three
decades. This indication of the economy’s fragility had led us to be
short of the yen in anticipation of it weakening. Many have been
bearish on the yen for a long time, indeed Japan has been in a
deflationary spiral for some twenty years. A weaker yen is one remedy.
We have no crystal ball but take the view that overvalued situations
eventually correct. The Bank of Japan continued with quantitative
easing and in February was explicit in setting a goal of 1% inflation at
a time when the current inflation rate was -0.1%.
Identifying overvalued situations where fundamentals are likely to
deteriorate is not difficult. However what adds uncertainty is the extreme
short-term nature of global capital flows. In South Africa, we were short
of the rand (against the Mexican peso, where terms of trade and exports
are improving) because the labour and political situation continued to
deteriorate, thus weakening the fundamentals for the economy. This
position has not yet yielded results because, as an emerging market,
the country received periodic inflows of global capital such that the rand
can rally strongly during ‘risk on’ periods. In addition, passive inflows
intensified after the South African bond market was included in the
World Government Bond Index in autumn 2012.
The launch of future contract in French OAT bonds provided us with
an opportunity to open a short position as we anticipated deterioration
in that market as the debt crisis continued to claim larger scalps. In our
view, the yield gap between French OATs and German bunds was too
narrow, making the former vulnerable because of fundamental
weaknesses in France’s economic fabric.
Investment Outlook
In the face of a global economic slowdown and debt deleveraging,
central banks around the world have redoubled their efforts to boost
growth. However, it is of concern that they have begun to make a
habit out of the unconventional monetary policy that was once
considered a necessity.
Without private demand for loans, the massive amount of liquidity
created by central banks stays mainly within the financial system
pushing the yields on bonds down and the price/earnings ratios on
shares up. Asset prices then fluctuate according to news flow rather
than reacting to fundamentals.
Zero interest rate regimes may even be a trap, i.e. hard to get out of.
When private demand for loans eventually returns and the money
supply balloons, central banks will have to mop up excess liquidity fast
to contain inflation. However, aggressive tightening risks jeopardising
a nascent recovery, whereas any delay could raise inflation
expectations and send bond yields sharply higher. Either way a major
ordeal awaits bond markets.
Mindful of this, the Fund’s largest active exposures are short positions
in sovereign bonds, reflecting their extreme overvaluation. It is also
positioned to take advantage of certain distortions in currency
valuations and to maintain some exposure to equity markets through
convertibles as central banks appear intent on keeping the show on
the road.
Miles Geldard and Lee Manzi
30 October 2012
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