(Prepared January 2012)

The investment environment continues to be clouded with uncertainty as we enter 2012 with major dislocation of markets across Europe as it focuses on sovereign debt issues and an increasing pressure on the European banking system. Europe has too much debt which needs to be reduced via deleveraging and the Central Bank (ECB) has to provide support for financial stability through a program of quantitative easing and an orderly fiscal austerity undertaken by each of the Euro zone countries. The Euro zone politicians continue to delay critical decisions, which creates further uncertainty with the result Europe is now heading for recession and a long period of low growth. The Euro currency is likely to also weaken further as the market forces impact.

Investor confidence continues to remain subdued as the focus on the European debt crisis solution remains largely unresolved. Financial markets continue to react nervously to this uncertainty. The developed world countries of US and Japan continue to also deal with large debt levels and anticipate low growth levels over the coming year.

The US is now in an election year which will deflect major issues and should see a focus on job creation to lower the unemployment rate which has now dropped below the 9% level. The underlying US economy continues to produce positive growth although at low levels (in the region of 2%) and a flat share market. US consumer confidence is improving from a low base while US corporates are the bright spot for the economy, delivering solid earnings. They are generally well cashed up and have access to funding at very low rates (1-2%) and a weak US$. Inflation in the US is not an issue at this stage [although in the region of 3.5% and 10 year bonds around 2%] interest rates are likely to remain on hold for at least the next few years as the authorities try to manage the economy.

The emerging world is in good shape and is likely to account for most of the global growth in the year ahead. China remains key to world growth and is presently undergoing a slowing in growth. Exports are showing clear signs of being impacted by the slowdown in Europe and the US. The slowing is also a result of the Chinese leadership policies to restrain lending and reduce inflationary pressures in both goods and services, and property. The Chinese Yuan has slowly been allowed to appreciate against the US$ and this should assist in controlling the inflation level.

The Australian financial markets are also currently clouded by uncertainty as it adapts to an uncertain global environment. The positive for Australia is that it is now linked more and more into China and the greater Asian economies. This should provide opportunities in our financial markets over the medium to long term. China is not immune from the problems of the western world and is also being impacted by the slow down which is having flow on implications for Australia, especially for commodity prices.

Some of the likely headwinds for the Australian market include the very negative global sentiment emanating from the high debt levels, especially in Europe, the US and Japan. As well the strong A$ currency is making it difficult for manufacturers, exporters and tourism. In addition the political instability creates uncertainty. 

Energy and resource related companies within the Australian economy are likely to provide the lead for the coming year. Substantial investment is being made into the gas and energy sector which should underpin the growth rate. Although the resource sector is undergoing a commodity price decline led by iron ore dropping in the region of 30% over the past six months. Other sectors of the economy have also slowed with retail and industrial being particularly weak largely as a result of the high A$. This has led to the RBA cutting rates in order to provide a boost to the economy. The RBA has moved into an interest rate easing period with the cash rate dropping to 4.25% and further cuts appear likely during 2012. Investor appetite is likely to be fickle over the coming months as market volatility remains high and markets react to the European debt issues. 

Confidence is likely to be the key driver of equities and property markets over the coming year, although very negative at present. The high A$ should be supportive for global investing on an unhedged basis. The weak US$ is currently underpinning the strength of the A$ as well as the interest rates and commodity prices. Managers with good stock picking skills should outperform in this environment. Equities valuations appear attractive although the global environment is not supportive to growth assets. The focus on quality stocks along with dividends and high yield should ultimately reward equities investors over the medium term.

Commercial and retail property valuations are starting to offer better value and long term investors are likely to slowly re-enter the market over the coming year as the next cycle emerges. Access to funding is still the key restraint for the commercial and retail property markets. 

International shares: [Neutral] A strong Aust$ v US$ provides opportunities for international shares and a benchmark weighting is appropriate for the sector. Asia and emerging markets remain long term growth regions. Stock and country selection is going to be much more important over the coming year as volatility remains high. Europe is likely to remain subdued. 

Australian shares: [Overweight] Australian Small Caps: [Neutral] Valuations have become more compelling as the negative environment impacts the equities market. The focus should be on quality companies with strong income streams in this environment. Consider an overweight weighting appropriate on a three-year outlook. 

Australian Listed Property: [Underweight] Global Listed Property: [Underweight] Property securities are likely to under perform equities on a three year outlook and suggest under weighting the sector. Quality direct property valuations are starting to show signs of recovery although likely to be slow as access to funding remains difficult. The listed property sector remains subdued. 

Fixed Interest: [Underweight] With interest rates at low levels globally and in Australia, opportunities for fixed interest are likely to be limited over the coming year. An underweight for the sector is appropriate. A cautious approach to sovereign debt is required with opportunities for corporate bonds preferred. 

Cash: [Overweight] The risk return profile of Cash and Term Deposits are attractive when compared to cash based funds and those fixed interest funds with an allocation to sovereign debt. 

Risks  

The risk of sovereign debt defaults remains high with the large deficits being run by many countries. They now need to manage carefully the wind back. Investors need to be selective.

The European Union faces major challenges in managing member countries, especially Greece, Italy, Ireland, Portugal and Spain with large debt issues and the lack of discipline to control the predicament.

Growing tensions in the Middle East, especially Iran may lead to an escalation in the oil price.

With large US debt levels, strong political will is required to enact the necessary measures to reduce the debt levels. This is likely to be difficult as the US goes to an election this year.

China’s policies, (especially in relation to currency management) and actions in doing business with the US and other major trade partners is likely to be a major influence on world markets.

Increased regulation of the financial system (banks) by governments is likely to add to the uncertainty of markets over the coming year.

Poor implementation and execution of the carbon tax and mining tax could create a significant risk to the Australian economy and markets, especially if our international competitiveness is eroded. 

Global  

The Asian region including India continues to generate satisfactory GDP growth, although slowing and should continue to be a major driver of world growth. Asia should continue to create opportunities for Australian investors although with periods of volatility like we have been experiencing.

A key factor for continued Asian growth will be the increasing demand by China’s consumers as they develop greater wealth and require ever increasing volumes of commodities and agricultural products, which should underpin the Australian resources and agricultural sectors over the longer term.

With global uncertainty gold is playing a more dominant role. 

Australia  

Resources and energy remain key to the strength of the economy and should continue to play a leading role in the market direction during 2012. Significant capital expenditure is being committed to the energy (gas) and resources sector over the coming years. 

Opportunities should continue as China and India evolve into stronger economies over the coming decade and demand for quality Australian resource companies exporting to China and India should be under pinned over the longer term. 

Fixed Interest and Property  

Opportunities for higher returns from traditional fixed interest have been reduced with interest rates at low levels although Australia in the short term is likely to benefit from an expected further lowering of interest rates. Limited opportunities prevail in the lower grade credit markets.

The listed property trust sector is now in better shape to participate in a stronger property cycle. 

 Returns greater than 1 year are annualised.