In this week’s video insight, I’ll be discussing the pleasing performance of both the Montgomery Small Companies Fund and the Aura High Yield SME Fund (for wholesale investors) in the September 2023 quarter. During this time stock markets observed widespread negative returns, mainly due to a significant increase in U.S. ten-year treasury bond yields.

I also wanted to highlight the potential from continued market volatility, the unusual removal of the U.S. House of Representatives Speaker, and the uncertainties surrounding the U.S. government’s fiscal situation. I’m particularly concerned about the rising U.S. budget deficit and debt-to-GDP ratios, which may lead to investors demanding higher premiums for U.S. treasury bonds. This trend is influenced by historical data on risk premiums and inflationary expectations, and it adds to the challenges people face dealing with the increased cost of living. Furthermore, if inflationary expectations persist, it could significantly impact asset valuations.

Transcript:

Hi, I’m David Buckland, and welcome to this week’s video insight. In the September 2023 quarter, virtually all the benchmarks for our business partners’ products recorded a negative return. Examples included the ASX Small Accumulation Ordinaries Index, down 1.94 per cent, the ASX 300 Accumulation Index, down 0.84 per cent, and the MSCI World Accumulation Index, in Australian Dollars, down 0.37 per cent.

This was largely driven by the jump in yield for the U.S. ten-year treasury bonds from 3.84 per cent to 4.57 per cent.  In recent days they have in fact breached 4.80 per cent. This sell-off coincided with the thesis that “interest rates will be higher for longer”, as the victory against inflationary expectations may have been called prematurely.

In that context it was pleasing to see two of our business partners’ products recording very pleasing positive returns over the September 2023 quarter. The Montgomery Small Companies Fund recorded an excellent return of 8.19 per cent, against its benchmark of over 10 per cent. And, the Aura High Yield SME Fund, available for wholesale investors only, was up again solidly by 2.42 per cent, with an average monthly distribution of 0.80 per cent.

Volatility could continue in the near-term. The recent removal of the speaker of the U.S. House of Representatives, Kevin McCarthy, is unprecedented. The U.S. Government is currently “open” only until mid-November, and this is not a good omen. The U.S. has not produced a budget surplus in two decades and negotiations, particularly with the hardline Republicans, will be delicate. 

The U.S. budget deficit to gross domestic product (GDP) ratio appears to be heading up from 6 per cent whilst the U.S. Federal Debt to GDP ratio looks set to beat its 1946 record, exploding through 100 per cent and possibly 120 per cent in the foreseeable future. I wonder if investors will demand a greater premium, relative to inflationary expectations, to buy U.S. ten-year treasury bonds. 

In a recent blog, I pointed out that in the period 1980-2001, for example, the average “risk” premium, relative to inflationary expectations, was 4.35 per cent. In that 20 odd year period, average ten-year treasury bonds were yielding 8.35 per cent and the cost-price index (CPI) reading averaging 3.90 per cent.

For the 2009-2021 period, the U.S. Federal Reserve and many other Central Banks kept their official cash rates close to nil, and this has now proved far too accommodative.

How are people surviving higher cost of living pressures with elevated costs of energy, fuel, food, interest expenses, rent, tolls, travel, and healthcare? Any thesis that says inflationary expectations have not necessarily been beaten could see the “risk” premium required for Government Bonds jump further.  And this would likely see additional pressure on various asset valuations.