Good afternoon,

I hate to be the barer of bad news but the ASX200 is down 0.84% today and 1.68% for the past week as Trump’s trade war with China (and now Mexico) has spooked investors and raised concerns about the potential impacts of global economic growth.

This fall in growth expectations is best demonstrated in the bond market. When growth expectations fall, bond investors accept lower returns meaning prices go up and yields fall. Here’s the six month change in bond yields for each of the main developed market geographies:

Source: Macquarie Research

Over the past ten years, investors have become used to falling bond yields as central banks around the world have supported asset prices by printing money and buying bonds. Now that this has slowed, falling yields mean falling growth expectations and potentially falling earnings.

Why does Australia, the US and Canada have the worst ‘growth revision’ in the bond market?

It’s all about China…

A “my tariff is bigger than your tariff” spat between China and the US would be negative for GDP growth in both countries and subsequently, commodity demand from Canada and Australia.

If you want to learn why tariffs are bad for GDP growth, you can pay a university $8,000 and do Macroeconomics 201 or read this.

What’s it all mean for markets?
It’s quite tricky. You’d think if these China tariffs play out, companies with high exposure to China will see margins decline as they have to absorb the tariff in their margins or pass it on in the form of higher prices, which risks a fall of demand. The reality is that data from April (pre-trade drama re-escalation) was weak out of the US, and this little indicator from Morgan Stanley tells the story, with their strategy team calling a US recession.

That’s worrying, even locally. With not a lot of valuation upside from here in the ASX as I don’t think we are getting broad-based earnings expansion (maybe a bit from the artificially elevated iron ore price), I think it’s time to take profits and get defensive.

ASX200 PE and earnings growth for the next 12 months below.


Sensible ways to make money out of a falling market (without holding cash)

The return on cash at the moment is c. 2% which in real terms is 1%, which is the integer next to nothing (sorry, bad math joke). I’m not averse to holding cash, but I think you want to balance your “defence” in case you are wrong because, at 1% return, the opportunity cost of being wrong is potentially high.

If you don’t want to hold cash, and don’t want to short stocks (expensive), here are a few ways that you can make money/lose less money while the market is falling.

Covered Calls
If you hold large, liquid companies in your portfolio (think ASX50 or so), you can probably use derivatives to generate additional income while your holdings aren’t appreciating in value.

Say you had 1000 CBA shares at a cost base of $73.00 and the current market price is $78.50. You could agree to give another person the right, but not the obligation to buy your CBA shares at $79.00 between now and the 19th of December 2019.

This “right” or “option” is worth something, and that something is called “premium” – which you receive today. In today’s market, that right is worth $2,680 for 1000 shares. That’s an annualised return of 5.48%.

If you’re counterparty “calls” the 1000 CBA shares from you, you have to sell them at $79.00 or a $500 profit. This income is additional to dividends, and while supersizing your income returns, you limit your upside – which isn’t a problem if you think there isn’t much upside.

At Seneca, we have 3 Level-2 accredited derivatives advisors (myself, Victoria and Angela) who can assist you in executing this (or any other derivatives strategy) across your portfolio.

However, if you’re lazy and just wanted to buy an ETF that does this:

You could take a look at the YMAX ETF from Betashares – but this thing has underperformed and has a worse risk/reward (sharpe) ratio than just owning its benchmark (ASX 20). It costs 0.80% in fees to own it.
The yields are above 11% including franking (which on paper is great)
But the yield on the ASX 20 is 5.12% anyway. You can own this for a 0.24% fee from iShares

My main issue with this ETF is that I think you can do it better/smarter if long-term income is your objective. However, for the purposes of hedging against medium-term volatility, it’s not a bad way to do it.

Buying Insurance (Puts/Mini Warrants)
If you are concerned about a specific holding or the broader market, you can purchase insurance for your portfolio or use the insurance derivatives to trade your expectations. Buying put options or put mini-warrants can hedge your long portfolio exposures for a short period with a relatively small capital outlay upfront with limited costs.

I generally prefer the mini-warrants for active trading on specific stocks. The leverage is more predictable, and you can trade at Delta-1, though you need to understand your upside risk as being stopped out, which can be frustrating. I think put options work better for hedging market exposure (beta) or longer-term hedges (3-12 months).

If this just went over your head, don’t worry. I’m happy to explain it to you over a coffee/call.

Gold
Physical gold, gold futures and gold stocks have been decent ways to hedge in short term market drawdowns. While it doesn’t have a perfect negative correlation with markets and other factors are influencing its price, it’s pretty safe to say that when volatility spikes/is expected to spike, gold outperforms. A few simple ways to get exposure:

Gold stocks – VanEck Vectors Gold Miners ETF, which is a market capitalisation weighted index of global gold mining companies (Newmont, Barrick, Newcrest, AngloAshanti etc.) Correlation to the ASX 200 since 30 June 2014 is -1.43%
Physical gold in AUD – BetaShares Gold Bullion ETF – Currency Hedged, backed by physical gold bullion and hedged to the AUD, yet you can trade like any other shares. Correlation to the ASX 200 since 30 June 2014 is -13.80%

There have been 28 months of negative returns on the ASX 200 since 30 June 2014, in which the average monthly return is -2.42%. The Gold Miners ETF averaged a +1.12% return while the Physical Gold in AUD managed a +0.57%.

On the flipside, in the top-performing 28 months on the ASX 200, the market did an average of 3.12% while these two ETF’s only did -0.82% and -0.49% respectively.

The takeaways:

Gold as a hedge works
Gold stocks are more leveraged & volatile than physical gold

Hybrids
Fixed income can get a bad wrap. It’s about as sexy as Andy Ruiz Jr. (though I wouldn’t say that to his face) but while your bank shares might fall 10,15, 20% in a market drawdown, hybrids stay pretty flat and trade in a c.3-5% range. Below is a chart of a CBA hybrid (CBAPE) and CBA shares, since 1 May 2016, excluding dividends to illustrate my point:

The hybrid will offer you about a 5.5% return with no real capital growth while the shares pay about an 8.5% dividend with the potential for capital growth. If you saw more than 5% downside in the share price in the short term, you’d probably switch.


Movers & Shakers

Real quick wrap on the big movers as I’ve written too much already.
Positives

The market loved the new leadership and plan at ECX after clearing the decks at the half year – a statutory loss of $120.3 million for the six months to March 31 due to a previously announced $118.4 million write-down of goodwill for the company’s graysonline.com auction business and Right2Drive accident loan division.
Lynas, Syrah trading like a yoyo on China/US rare-earth battle
Gold stocks make up the other positives.

Negatives

Costa Group updated the market, guiding to 15-25% lower profits on what has been a horror year. Agricultural risk or strategic misstep?
Link Administration had a big miss, proving to everyone its status as CPU’s very poor cousin is here to stay.
Otherwise, it’s a bunch of names with growth concerns, global exposure or dodgy balance sheets, which makes sense given the market sentiment this week.

Have a good week,
LL