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Key Messages: May 2015
Performance
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Models are currently performing well
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Risk and Return
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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
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Australian shares
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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
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Australian banks to face higher capital requirements
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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 $2.4 in
capital
Possible flow on effects:
 capital raising by banks
 slow down mortgage lending
Also Australia may get a credit
downgrade in the not to distant future
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Current risk in banks is largely a price
risk
To get more systemic type of risk we
would need to see a significant
slowdown in the Australian economy,
which is not currently happening
Morgan Stanley view of banks-
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Banks
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BHP demerger
BHP retains
32 south retains
+lead, coal, zinc and silver
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International
shares
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Selective opportunities plus the currency effect
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As previously documented there are
good opportunities selectively in the
international shares asset class
Both sets of models are tilted in the
right direction
The managers we are using Epoch,
Platinum, Magellan have navigated
difficult times in the past well
We think if things were to get worse
than expect the A$ 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
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Non US developed world and EM cheap
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US biggest risk-from a valuation perspective
Current CAPE around 27x
Generally the worst outcomes require overvaluation plus a recession
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One possible reason not to worry about the US
just yet?
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USA
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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
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Fed and the market
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China
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Chinese economy slowing albeit from high levels
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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
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China industrial economy slowing
Source Morgan Stanley April 30th 2015
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China consumption slowing
Source Morgan Stanley April 30th 2015
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Demographics keeping labour market tight
Gives government room to move
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China fixed asset investment slowing
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China property sector
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Some government stimulus has been enacted
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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
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Australia &
Scenario 3
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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?
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Australia
• 3 reasons why the full impact is being delayed
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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
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Expenditure effects: started but more to come
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Deloitte economics: impact of the economy
on the budget
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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
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Modest downgrade will pressure government
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Some positive east coast wealth effect?
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Spilling over into a mini construction boom
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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
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Scenarios
&
Investment
strategy
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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.
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