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Key Messages: May 2015 Performance 2 Models are currently performing well 3 Risk and Return 4 New initiatives • Currently looking at options for the Matrix and possibly the ClearView fixed interest component of models • Matrix is currently “bar belled” cash and equities, no duration • ClearView is overweight fixed interest • Under Scenario 3 its possible that bonds again outperform cash in the next 12 months • We will report back when we have completed this review about possible changes 5 Australian shares 6 Australian shares • Met with Schroder to discuss portfolio • Attended lunch with BHP CFO and head of marketing • Overall thoughts & feedback Banks look expensive, may face a few new headwinds in the not too distant future. Might need a rise in unemployment and bad debts to get a significant shakeout in this sector BHP looks to be sitting on very high quality assets, not committing any more capital to iron ore expansion, looking for higher cost producers to exit market 7 Australian banks to face higher capital requirements • • • • • • CBA, ANZ and WBC have all reported flat earnings Glen Stevens head of the RBA in a recent speech hinted at higher capital requirements. APRA also on record with respect to this. Probably increase capital requirements on mortgages from 18% to maybe 28%? (Morgan Stanley opinion) So move from requiring $1.4 in capital per $100 in mortgages to $2.4 in capital Possible flow on effects: capital raising by banks slow down mortgage lending Also Australia may get a credit downgrade in the not to distant future • • • Current risk in banks is largely a price risk To get more systemic type of risk we would need to see a significant slowdown in the Australian economy, which is not currently happening Morgan Stanley view of banks- 8 Banks 9 BHP demerger BHP retains 32 south retains +lead, coal, zinc and silver 10 International shares 11 Selective opportunities plus the currency effect • • • • • • As previously documented there are good opportunities selectively in the international shares asset class Both sets of models are tilted in the right direction The managers we are using Epoch, Platinum, Magellan have navigated difficult times in the past well We think if things were to get worse than expect the A$ also could fall a lot further partially hedging our position The risk is the US equity market which is significantly overvalued Overvaluation tells you a lot about the long term but very little about the next few years 12 Non US developed world and EM cheap 13 US biggest risk-from a valuation perspective Current CAPE around 27x Generally the worst outcomes require overvaluation plus a recession 14 One possible reason not to worry about the US just yet? 15 USA 16 Weak first quarter • US economy clearly weak in first half of the year • Opinions very mixed on whether this is a weak first half/strong second half model or the start of something more serious. • We don’t have a strong view yet on this matter • What it probably does is increase the potential risk in US shares in the next few months given the very high valuation levels we have previously discussed 17 Fed and the market 18 China 19 Chinese economy slowing albeit from high levels • • • • • • 1st quarter GDP “official +1.2% QoQ, YoY 7% Almost all economic commentators have it at much lower growth levels Government staying the course opting for “creative destruction” Unemployment not such a problem given poor demographics We reiterate our view this transition is both good and necessary for China, however it will probably be a very difficult period for Australia given our commodity focus This slowdown is however from a very high base, in many cases current growth rates are very high in absolute terms. Just not as strong as they were 20 China industrial economy slowing Source Morgan Stanley April 30th 2015 21 China consumption slowing Source Morgan Stanley April 30th 2015 22 Demographics keeping labour market tight Gives government room to move 23 China fixed asset investment slowing 24 China property sector 25 Some government stimulus has been enacted 26 Summary • Chinese growth is still pretty good, probably closer to 45% than 7% however • Slowdown is fairly widespread • Thus far the government is holding its nerve • A necessary slowdown, part of moving the economy away from commodity intensive investment based model • Good for some markets/shares bad for others- so we see the Chinese share market rallying and Australian resource stocks falling • To us this suggest that the focus on a China slowdown remains very relevant for us as investors 27 Australia & Scenario 3 28 Scenario 3- China slowdown • Clear China is slowing as predicted • A$, Iron ore, Aus share market under performing unhedged international shares, Aus bonds strong • All more or less as expected so models are doing well • However Scenario 3 predicts negative absolute returns in Australian shares which hasn’t happened and a weak Australian economy which has partially happened • Why? 29 Australia • 3 reasons why the full impact is being delayed • • • • • 1) The lagged effect of the end of the mining boom, trailing of gradually 2) Some of the “income effects” will take some time to flow through Example of income shock being delayed: A booming Australia could get by with low tax rates and generous breaks in super, capital gains, negative gearing etc Australian government now faces budget deficits for a long time, but policy has not yet been tightened. So we are living beyond our means and running up debt to do so 3) East coast speculation in residential property is keeping the east buoyant We see these things as delaying bit not averting the impact from China and so expect further weakness in the Australian economy as the China slowdown continues 30 Expenditure effects: started but more to come 31 Deloitte economics: impact of the economy on the budget 32 Budget deficits Right now we get all the income from tax breaks and benefits, by paying for them with growing debts (budget deficit), soon the government will have to tighten their (and our) belts 33 Modest downgrade will pressure government 34 Some positive east coast wealth effect? 35 Spilling over into a mini construction boom 36 Summary • We think that the share market is misreading the situation • China is clearly slowing right now, and iron ore prices have fallen, so the market has focused on this as the key impact of a slower China. • While in our view ignoring the delayed effects of the fall in mining capex, and new income strains on the Australian economy • So still happy to be positioned for our “scenario 3” and still expect more pronounced relative underperformance of Australian shares 37 Scenarios & Investment strategy 38 No changes to Scenarios • After last months update we have not made any changes to our Scenarios • Still focused on the scenario three outcome- China slowdown • Both sets of models will outperform in this Scenario • We are likely to move the Matrix models fixed income component into a blend of high quality credit, some bonds, and maybe some absolute return fixed interest strategies. 39