The Markets by maclaren1


									31 August 2009

The Markets

International Equities
Equities gain on positive economic data

Global sharemarkets extended their gains in August, supported by continued evidence of a global economic rebound and
improving prospects for corporate earnings. While developments during the month continued to provide evidence of
economic stabilisation, steps by the Chinese authorities to curb lending and investment sparked a sell-off in the Chinese
sharemarket and added to the volatility in global markets during the month.

Policy makers were encouraged by the general improvement in economic conditions but have not yet signalled plans to
remove expansionary policies. The Bank of England (BoE) surprised markets by expanding its quantitative easing program,
as there are lingering concerns about the sustainability of recent improvements.

The major developed equity markets ended the month higher. The European markets outperformed, with Europe ex-UK
shares up 5.19% during the month, while UK shares gained 7.17%. The US market gained 3.61%, while Japanese equities
lagged with a gain of 1.65%, weighed down by uncertainty about the recent elections. Financials outperformed as investor
risk appetite improved. Hedged international shares gained 3.32% in August.

Outlook: Equity valuations no longer appear extremely cheap, but scope exists for gains if the global economy continues to
recover. With risks to growth still present, the key question is whether the recovery will continue through 2010 or if
growth will suffer a relapse. We see risks as balanced at this stage.

Australian Equities
Australian shares gain on global optimism

The Australian sharemarket gained 6.57% in August, outperforming other major developed equity markets. The local
market performed strongly, despite a stronger Australian dollar (AUD) and higher short term interest rates, and the
decline in the domestic economy appears less severe than first feared. Financials outperformed the broader market,
gaining 13.3% on better than expected bank earnings and analyst upgrades. Resource stocks lagged, with some caution
developing about the sustainability of Chinese growth.

Outlook: There are a number of factors that should support Australian shares, reasonable valuations, high dividend yields,
low cash rates and the fact that banks are relatively well capitalised compared to global peers. However, valuations are
not as attractive as in other markets.

Global Fixed Interest
Bonds yields lower in August

Global bonds gained in August despite generally stronger economic data and buoyant equity markets. The BoE’s
announcement that it is expanding its quantitative easing program also helped support the markets. The US ten year bond
yield finished the month lower at 3.4%. Australian ten year bond yields finished the month lower at 5.42%. This was

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despite a sharp increase in the market’s expectations for rate hikes by the Reserve Bank of Australia (RBA), with some
speculating that the RBA may raise rates as soon as October. The Barclays Capital Global Aggregate Index returned 1.26%
in August.

Outlook: Bonds are generally close to fair value in most markets. While the global economy has shown signs of
improvement, cash rates are likely to remain low for a prolonged period. Recent concerns about inflation are overdone
given the large excess capacity within the developed economies.

US dollar (USD) weaker on global optimism

The USD underperformed other major currencies as better economic data supported investor risk appetites, while the
expansion of the BoE's quantitative easing program helped drive the British pound (GBP) lower. The AUD ended the
month higher at US$0.84 due to expectations that the RBA might be one of the first central banks to raise interest rates.
Returns on foreign currency exposure were -1.30% against the international equity benchmark.

Outlook: We see the AUD as somewhat above its fair value; however, the currency is supported by high relative interest
rates. China's robust growth is likely to support the terms of trade. The outlook for the USD is more mixed, valuations
are somewhat attractive but the reliance on foreign investor purchases of Treasuries remains. We expect the euro to
weaken, as the region is likely to experience relatively lower economic growth.
Financial markets (%)
Sharemarkets                                        Level as at   1 month     3 month        Financial     1 year return
                                                    31-Aug-09      return      return       YTD return
Australia (S&P/ASX 200)                                 4479       6.57         18.94          14.36           -8.06
World (MSCI World ex Aust.)                             775        3.61         11.07          11.30           -17.73
US (S&P 500)                                            1020       3.61         11.67          11.45           -18.25
UK (FTSE 100)                                           4908       7.17         12.38          16.36           -8.89
Europe (MSCI Europe ex UK)                              864        5.19         14.03          15.26           -14.85
Japan (Topix)                                           965        1.65         7.48            3.90           -21.41
Australian Dollar/US Dollar                             0.84       1.41         5.32            4.28           -2.11
Australian Dollar/Euro                                  0.59       0.19         3.88            1.92            0.43
Australian Dollar/Yen                                  78.21       -1.18        2.35            0.26           -16.32

Sharemarket returns are inclusive of dividends, in local terms.

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Economist's View

Key Points

• Economic recovery confirmed - growth spreads across the global economy
• Risk aversion continues to abate in financial markets - credit markets improving
• The outlook - short term is positive but headwinds in the medium term
• The miraculous Australian economy - GDP defies the odds

International Economies
Economic recovery confirmed - growth spreads across the global economy

Gross domestic product (GDP) releases have confirmed that positive growth extended beyond China and other
emerging Asian economies to Europe and Japan in the June quarter. Within Europe, both the German and French
economies expanded by 0.3%, their first quarterly GDP growth since the first quarter of 2008. Growth in the German
economy was supported by strong household and government consumption and construction while the French economy
was supported by the external sector. The growth in Europe’s two largest economies contributed to the Euro area
contracting by only 0.1%, which was substantially less than the expected 0.5% contraction.

The Japanese economy also expanded during the June quarter, driven by international trade and support from a
substantial fiscal package. Also within the region, Hong Kong, Taiwan, Thailand and the Philippines all registered strong
positive GDP growth in the quarter.

In the US, the June quarter national accounts revealed a smaller than expected 0.3% contraction as fiscal stimulus
supports private and public sector spending. Ongoing fiscal stimulus combined with low interest rates, a stabilising
housing market and a recovering global economy should allow the US economy to grow at around trend during the
second half of 2009.

Risk aversion continues to abate in financial markets - credit markets improving

Equity markets continued to rally during the month, with the Morgan Stanley Capital International (MSCI) World Index (in
local currency) increasing by 2.7% to be up by approximately 46% since its low point in March. Confidence in the banking
sector also continues to improve. The US three-month interbank to OIS (overnight-indexed swaps) spread has reached a
two year low of around 0.14% and is now only marginally higher than its pre-crisis average of around 0.10%. Within credit
markets, risk aversion is also moderating, with the spread between BAA rated US corporate bonds and US 10 year
sovereign bonds falling by around 0.38% during the month. In addition, global central banks continue to signal that the
economic recovery is gaining traction. The US Federal Reserve (Fed) recently stated that “economic activity is levelling
out” following improvements in financial conditions. However, the Fed still sees the need for accommodative monetary
policy and has extended its asset purchase program to October. The Bank of England (BoE) is also cautiously upbeat,
stating that “the probability of activity contracting for a further sustained period is judged to have fallen”, reflecting the
recent increase in monetary stimulus. Despite this, the economic recovery in the UK is expected to be slow, with
inflation likely to remain below target in the medium term.

The outlook - short term is positive but headwinds in the medium term

Stabilisation within the manufacturing sector has been a key driver of the rebound in global growth. Following the
improvement in Purchasing Managers Index (PMI) surveys, French and US industrial production firmed in June and July
respectively, while Japanese machinery orders increased substantially in June. Global manufacturing activity continues to

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firm, with the August US ISM survey and the German, French and UK PMI surveys rising above the critical 50 point
barrier, signalling an expansion in the manufacturing sectors of these economies.

Also within the US economy, the housing market has been exhibiting signs of stabilisation, with house prices rising for the
second consecutive month. Demand for housing is also recovering, with existing and new home sales rising in July.
Stabilisation of the US housing market is critical to the ongoing recovery in the US economy due to its influence on
household wealth and bank balance sheets. In addition, the American Recovery and Reinvestment fiscal package will
provide considerable support over the next six months, although this will be in the form of government infrastructure
spending rather than direct household support.

While the short term outlook (i.e. the next six months) appears positive for global growth, headwinds to the medium
term outlook are developing. Within financial markets, equity prices are at or above most standard measures of fair value.
The large build in excess productive capacity within most economies has diminished the pricing power of businesses and
has therefore limited profit margin expansion. In recent months, cost cutting has increased profits, but the ability of
businesses to continue to cut costs is becoming exhausted. This should limit the growth prospects of profits and
therefore equity valuations. Consequently, the boost to household wealth coming from price increases in equities will

Global monetary policy settings remain very loose. Although rates will stay low for a while yet, central bank tightening is
now being factored in by the market and it is expected that bond yields will rise in the future. Consequently, the private
sector will be faced with rising interest rates and diminishing support from fiscal stimulus in the second half of 2010.

Finally, despite the recovery in global growth, most economies will continue to experience excess capacity in production
and rising unemployment rates as the damage done by the shock in 2008 and the first quarter of 2009 takes time to
repair. This means that over the remainder of 2009 and into 2010, the household sectors in most developed economies
will experience rising unemployment and falling wages at a time when direct fiscal support has ended and interest rates
are likely to rise. These factors will act as a drag on consumption expenditure and limit the pace of recovery in those
Interest Rate Forecast (%)

                                       Level at                                      QIC forecast
                                     07 Sep 2009               Dec-09                  Mar-10                   Sep-10

          Australia                    3.00                    3.25                     3.50                    3.75
              US                    0.00 - 0.25             0.00 - 0.25              0.00 - 0.25                1.00
           Canada                      0.25                    0.25                     0.75                    1.50
           Europe                      1.00                    1.00                     1.00                    1.00
              UK                       0.50                    0.50                     0.50                    0.75
            Japan                      0.10                    0.10                     0.10                    0.10

Australian Economy
The miraculous Australian economy - GDP defies the odds

The release of the June quarter national accounts confirmed the strong performance of the Australian economy, with real
GDP expanding by 0.6%. Following supportive fiscal and monetary policies, the household and government sectors
contributed to growth, while business investment was also surprisingly robust. Dwelling investment detracted from
growth during the first half of the year; however, forward looking indicators point to a recovery in the latter part of 2009.
Net exports detracted from GDP growth as the rise in export volumes failed to offset the increase in import volumes.

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Despite mining export volumes increasing in the June quarter, the resetting of bulk commodity contract prices led to
mining profits falling by nearly 25% for the quarter.

Given the strength of the economy, speculation continues that the RBA will commence its tightening cycle before the end
of the year. However, as in many other advanced economies, in the second half of 2009 the Australian household sector
will face rising unemployment and slowing income growth. Depending on how consumer spending reacts to these
headwinds, the pace of recovery may disappoint market expectations.

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