Strategic Insight
March 2008

Produced exclusively for Financial Planning & Life clients

INTRODUCTION:

The impact of the continued deterioration of global credit markets on developed economies remained throughout the March quarter. Volatility was again a key feature of equity markets throughout the quarter, with sentiment waning. Major equity markets slumped, Australia included. Locally, ASX listed companies Allco, MFS and ABC Learning Centres all succumbed to issues relating to debt obligations as the credit market woes continued to have a real impact on the local bourse. Australian bond yields were not immune from the volatility through the quarter; the 10 year bond yield ranged from 5.87% to 6.48% before ending at 6.05%, a fall of 28bps on end December yields. In what continues to be a difficult market, cash has been the best performing asset class over the last six months.

The world's largest economy, the United States, continues its move toward recession, with falling house prices, rising fuel costs and the increasing cost of credit slowing US consumption. The US Federal Reserve cut interest rates by 200 basis points (bp) in the first quarter of 2008 to 2.25%; this was coupled with the Government's $146bn fiscal stimulus package, both designed to lessen the impact of the economic slowdown.

While the slowdown of the US economy continues, the developing economies of Asia currently continue their growth story. The extent to which some of these developing economies continue to perform will be determined largely by the severity of a slowdown in the US and the expected decline in US imports.

Commodity prices maintained their bull run, with both Gold and Oil hitting record highs during the quarter. Gold pushed through US $1,000/ounce and Oil US $100/barrel for the first time. Platinum, Copper and Tin prices also rose by over 25% each over the quarter.

In continental Europe, the European Central Bank (ECB) expects growth to slow and in the UK the Bank of England (BOE) has moved to an easing bias, cutting rates on concerns of falling consumer sentiment. Recent market movements in foreign exchange markets have conspired to hurt the economy of Japan, driven by the increased value of the Yen and falling demand in the US. China and India are both expected to lead the developing Asian economies with robust growth forecasts, despite these forecasts being lower than recently observed levels in the region.

The Australian economy continues to exhibit strong growth (with GDP at 3.9%), supported by strong economic figures (low unemployment, federal budget surplus, strong AUD, record private sector spending and public spending on plant, equipment and infrastructure), and continued demand flow from the neighbouring growth economies of Asia. However, risks still remain; rising inflation and the threat of a slowdown in developed economies forcing commodity prices lower.

With the RBA raising rates twice through the March quarter, controlling inflation is clearly to the forefront in the Bank's actions. The domestic banks all passed on more than the RBA's increase to consumers, reflecting the increased costs of financing debt in the current climate.

The equity market suffered its worst quarterly return for 20 years as the credit crunch continued to be played out, with many speculating that we have yet to see the end of the fallout. Volatility is expected to remain a characteristic of equity markets over the coming months as investors take their guide from the next round of companies reporting, which is expected to give further insight into the depth of the credit market's impact.

The following Table sets out the returns for the last quarter and 12 months to 31st March 2008.

* Returns are in local currencies

** MSCI World ex Aust Index $A

OUTLOOK FOR ASSET CLASSES:

AUSTRALIAN SHARES:

Financial Planning & Life remains cautious on the outlook for the local share market and believes that short term sentiment is likely to remain negative. Rising interest rates and a slowdown in the US economy are both expected to provide the domestic share market with headwinds over the remainder of 2008. Despite the short term risks mentioned, the Australian economy is still expected to grow at a relatively robust pace of around 3.5% in 2008 (down from 3.9% in 2007), due to Australia's exposure to the growing Asian economies. This growth, however, will be largely dependant on the size and extent of the global slowdown in the coming quarters. Considering that 63% of Australia's exports are to the Asian region, a key issue for the Australian economy and share market going forward will be whether the developing markets of Asia can withstand a US slowdown.

The RBA raised interest rates to 7.25% during the quarter in an attempt to curb inflationary pressures brought on my low unemployment levels, rising wealth and income growth in Australia. Financial Planning & Life expects that the RBA is near the peak of its tightening cycle and that interest rates will remain on hold in the short term. Already there have been signs that the conditions are slowing, with consumer and business confidence, retail sales and building approvals all down over the March quarter. Financial Planning & Life expects share market volatility to continue, both domestically and abroad, until inflationary risks have abated and a clearer picture can be painted for a recover in the US economy.

The market is not expected to match the impressive double-digit returns of the past five years, and instead Financial Planning & Life expect the market to trade within a range of 5,000 to 5,800 points in 2008.

Overall we believe that the share market has reasonable earnings prospects for 2008, with broker consensus EPS growth in the range of 6% to 8%. Financial Planning & Life however believes that the market has already priced in this growth. Rising costs and a stronger AUD are expected to take some shine off the resources sector and EPS growth is expected to be in the range of 10% to 15%. In the Financials sector, Australian banks seem to be in better financial shape relative to their overseas peers and corporate borrowers will have to return to the banks for debt financing (due to current credit conditions), allowing them to increase market share. The Industrials sector is expected to deliver 6% to 8% earnings growth.

Portfolio Action:

Financial Planning & Life expects global growth to weaken over 2008, particularly in the developed economies of the US and Japan to 3.2%, from a previous forecast of 4.1%.

Offsetting this weakness, however, is the relatively robust growth expected to stem from the developing economies of Russia, India and China, which are well placed to withstand a US slowdown. Financial Planning & Life has therefore decided to maintain a 'neutral' asset allocation to international equities, which are expected to provide a more diversified exposure to growth assets relative to Australian equities. Accordingly, in Australian equities, we have moved to a 'slight underweight' position (from 'neutral'), reflecting the higher level of downside risk expected from domestic equities relative to global equities in the short term.

In addition to inflationary pressures, Financial Planning & Life has some short term concerns over the possible retraction of commodity prices and its impact on the local market which is highly concentrated in commodities and financials (in total approximately 61% of the market).

INTERNATIONAL SHARES:

The prolonged turbulence in global markets, largely attributable to the dysfunctional credit markets, continues to exert downwards pressure on global economic growth forecasts. The International Monetary Fund's latest 2008 global growth forecast has been revised down to 4.1%. There appears a strong likelihood that the extraordinary paralysis disrupting financial markets will continue to depress investment performance for some time yet.

Interestingly, while stock exchanges across many emerging markets also performed poorly over the quarter, the GDP forecasts for larger economies like China and India, while moderating, are still expected to remain relatively robust and come in at close to recent trend levels.

This is suggestive of a two-paced global economy with an expectation that the developing economies of Asia and Latin America will act as a greater engine room for global growth than the old world developed powerhouses of the G7.

United States

A steady stream of weak economic data in the US in the first quarter confirmed that the world's largest economy is grinding to a halt. Many market participants, including senior officials at the US Federal Reserve, are bracing for further contraction in the economy throughout the first half of the year. It is rare to find all but the most optimistic of commentators expecting a speedy recovery from the slowdown.

Speculation is rife regarding the likelihood of a US recession and, despite this economic scenario being as yet unconfirmed in the official numbers, many believe it is already a fait accompli.

The Fed is poised to continue its front line interventionist role in seeking to stabilise the market and provide some fiscal stimulus. Recent monetary tightening has reduced the Fed Funds rate to 2.25%, a fall of 3% since September 2007. While this action, combined with other policy initiatives available to the regulator, has provided some interim and short term bouts of confidence in equity markets, it is yet to deliver a knockout blow to the market's woes.

The weak employment data released in the last week of March suggests that further tightening and policy intervention may be necessary. The US economy lost 232,000 jobs in the first three months of the year.

The Fed is in relatively unchartered territory and has attracted some criticism regarding "the moral hazard" and the precedent which has been set by their response (direct intervention) to the crisis. It remains to be seen whether the Fed's actions in sponsoring JP Morgan's bailout of Bear Stearns proves a shrewd decisive action in preventing wide scale corporate financial contagion, or whether it is merely the first major A-List casualty in a string of failures resulting from corporate greed and impaired financial practice. If it proves to be the latter, the prospects may be ominous for the American taxpayer and the broader global economy.

Europe

The general outlook in European markets remains subdued, given the prospect of slower Eurozone economic growth driven by the effects of a stronger Euro, rising inflation, continued tightness in credit markets, and the prospect of recession in the US. The European Central Bank (ECB) expects European growth to moderate in 2008 to approximately 1.7%. Inflation remains a key focus for the regulator as it moved above 3.0% in February, driven by rising oil and food prices.

Meanwhile the Euro hit a record high against the US dollar in mid March, damaging the outlook for European exporters. In contrast to its US counterpart, the ECB continued to leave the borrowing rate unchanged at 4.0% throughout the quarter. There remains a sense that the ECB may eventually be prompted to cut the borrowing rate later in the year to offset the deteriorating economic outlook.

While conceding that economic growth might moderate slightly on previous forecasts, regulators in Germany remain cautiously upbeat about the ability of Europe's largest economy to weather the US slowdown. This judgement reflects Germany's perceived robust industry conditions and improved labour market framework versus many of its European peers.

Growth in the UK continued to weaken in the second half of 2007 with GDP coming in at 3.0% for the year. The trend is expected to intensify in 2008, with Treasury forecasting 2008 growth to be in the range of 1.75-2.25% as outlined in the UK Budget in mid March. Since December the Bank of England (BOE) has responded to the credit squeeze by reducing rates by 50 basis points to 5.25%. to the disappointment of some, the BOE left rates unchanged following its March meeting, citing fears about rising inflation taking precedence over concerns about the deteriorating economic outlook. However, if the BOE can maintain a degree of inflation control, there is expectation of future downside movement on rates to promote growth.

It proved an eventful quarter in France, given the trading scandal at Société Generale and the growing public doubts concerning the policies and broader character of the French leader. This culminated in the ruling Sarkozy-led party losing local public elections to opposition Socialists in March. Despite the faltering public support, the French administration reiterated no slowdown in its economic reform agenda tackling four key areas - improving competitiveness, stimulating growth, improving state finances and increasing efficiency of pension, health and welfare programs. These reforms have been broadly welcomed by the business community and many of France's EU neighbours. The sluggish economic outlook prompted the French government to pare back its 2008 growth forecast from 2.25% to 1.7 - 2.0%.

Japan

The US slowdown weighed heavily on investor confidence in Japan as signs of a possible domestic recession grew. Despite inflation reaching a decade long high of 1.0% in February (by no means high in an absolute sense but welcomed by locals as signalling a possible end to prolonged deflation) broader economic concerns meant regulators continued to leave rates unchanged at 0.5%. Indeed, the BOJ remained more disposed to cutting rates than any moves on the upside.

Japan's economy grew by 0.9% in the final quarter for 2007 driven by solid export performance. However, this export resilience is not viewed as sustainable, at least in the first half of 2008, particularly as exporters confront the effects of a rising yen. Household spending retreated in February and when combined with rising unemployment it would tend to suggest there is no rapid turnaround in sight for the poor comparative and absolute performance of Japanese equities.

Asia

GDP in China grew at 11.5% in 2007 and has triggered some fairly serious inflationary pressures resulting in policy responses in increased price controls and interest rate hikes. The Asian Development Bank (ADB) expects China's economy to grow by 10% in 2008.

The Indian economy expanded by 8.7% in 2007 and according to the ADB is expected to deliver GDP growth of 8%.

However the outlook is not as rosy for economies such as Singapore which are more heavily reliant on US trade and therefore more vulnerable to the effect of US recession.

Financial Planning & Life continues to recommend a 'neutral' weighting to international equities, reflecting the ongoing uncertainty surrounding global economic prospects.

The economic unravelling in the US is likely to dampen global investor confidence and restrict appetite for higher risk assets for the near term. We expect the outlook for global equities returns will remain volatile for the first half of 2008. While the sharp decline in equity valuations has prompted some recent market talk about greater buying opportunities, Financial Planning & Life is unable to 'call the bottom'. Rather, we continue to recommend investors ensure appropriate balance of 'value/growth' style investments within portfolios to ensure investors have appropriate opportunity to participate across the market cycle.

Traditionally, emerging market equities have performed poorly in times of global uncertainty, and there has certainly been a return to more traditional volatility levels in this asset class of late. Asian markets have corrected in recent months and it remains to be seen whether regional equities will continue to weaken in line with their developed peers or instead provide some moderate outperformance. As always, a longer term perspective is required when formulating global equities performance expectations. Investors may wish to review their international equities allocation to ensure appropriate emerging and Asian equities exposure so as to benefit from the shifting balance of the global economy and projected resilience of the BRIC economies.

PROPERTY:

It is impossible to predict whether the global property securities sector has finally reached the bottom of its fall. Whilst there now appears to be plenty of valuation upside in the sector, further bad news regarding the US economy could see REITs and property companies with exposure to US assets continue to experience pricing pressure.

Furthermore, if values in the direct property market fall, a reduction in net asset values (NAVs) could see the sector experience further pricing pressure and negative sentiment. Whilst talk of increasing yields (via falling property values) has been occurring for half a year now, there is still insufficient transactional evidence at this stage to confirm the extent to which this may have occurred.

Looking ahead, the global property sector could potentially achieve long term total returns of approximately 10% per annum, comprising a distribution income yield of approximately 3.5% - 4% and the rest capital growth. This is based on the assumption that interest rates will not change materially from current levels and that there will be a soft landing for the US economy. However, given the volatility in the sector, it is quite possible that global property will not see this type of return over 2008.

The domestic property market is likely to continue to correct as a result of the fall in asset values and deteriorating credit markets. Valuation decreases will likely be skewed towards lower quality stock.

A-REIT's with conservative gearing, a focus on quality domestic assets and no exposure to funds management and development activities are likely to be the better performers over the short term. Over the long term, Financial Planning & Life expects that the domestic A-REIT sector should deliver average long term returns of 8-10% pa.

Portfolio Action:

Financial Planning & Life has increased its allocation to property from 'underweight' to 'slightly underweight', reflecting the increasing valuation upside of the sector.

CASH & FIXED INTEREST:

The Australian economy is expected to slow over 2008 but remain relatively robust, with the major risks being inflation and any major slowdown in Asia. The December quarter national accounts grew at a solid pace of 0.6% (3.9% over 2007). Demand was strong across the board with Consumption, Government spending and Business Investment all contributing to growth. Households are enjoying strong income growth and rising wealth while company profits remain robust and balance sheets seem in good shape. At the same time the Federal Government is in a strong position, with a Budget Surplus of $17.3bn (1.7% of GDP).

Recent large increases in the price of iron ore, coal and gas have further improved Australia's terms of trade. With a solid economic growth outlook, a strong fiscal position, increasing terms of trade, and high interest rates relative to the G7 economies, Financial Planning & Life has an overall firm outlook for the AUD over the near term. That said, downside risks to the AUD versus the USD include Australia's high Current Account Deficit (-7% of GDP), any correction in commodity prices and the RBA cutting interest rates in the future.

Financial Planning & Life believes that the RBA is likely to keep interest rates on hold for the short to mid term. This should provide some respite to bond investors. Further, we suspect that the RBA is at the peak of its tightening cycle, with the next potential move being a cut - but not until 2009.

Portfolio Action:

Financial Planning & Life has an unchanged view for Australian fixed interest of a 'neutral' weighting. We retain the view that this asset class shows some value vis-à-vis cash. We view international fixed interest moderately negatively and we continue to prefer an 'underweight' position.

Notwithstanding this, the demand for 'safe haven' assets has given bond prices cause to rally. These higher prices are subject to readjustment should the Fed shift its focus to inflation management.

RECOMMENDED ASSET ALLOCATION:

MARKET MOVES - AS AT 31st May 2008:

Returns greater than 1 year are annualised.

Disclaimer: This document is for the exclusive use of the person to whom it is provided by Financial Planning & Life Pty Ltd (FP&L) and must not be used or relied upon by any other person. No warranty is given regarding accuracy or completeness of the information contained in this document, which is based on public information not verified by FP&L. Any opinions, conclusions, forecasts or recommendations are reasonably held at the time of compilation but are subject to change without notice and FP& L assumes no obligation to update this document after it has been issued. Except for any liability which by law cannot be excluded, FP&L, its directors, employees and agents disclaim all liability (whether in negligence of otherwise) for any error, inaccuracy in, or omission from the information contained in this document or any loss or damage suffered by the recipient or any other person directly or indirectly through relying upon the information. Any advice contained in this document is General Advice based on the investment merits of the security or issuer alone without taking into account any person's investment objectives, financial situation and particular needs. Before making an investment decision based on such advice, the recipient must decide whether it is appropriate to his/her investment objectives, financial situation and particular needs or seek specific professional advice. FP&L have sourced this document from Lonsdale Securities Ltd as their external Research Provider.

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