Financial Newsletter Sunshine Coast

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The main industrial economies continued to contract sharply in the early part of 2009. The US economy shrank by an annualised -6.1% in the March quarter, a similar decline to the previous quarter, while the UK economy contracted more sharply. Partial data suggests that the euro area contracted at least as sharply as in the final months of 2008. Indicators of retail sales and housing activity in the US also weakened in March, though this in large part reflected payback for weather induced strength in the prior month.

Forward looking data, however, has shown clear signs of a slowing in the pace of contraction in global activity, a theme markets believe reflects the ‘green shoots’ of a potential recovery.
Measures of business conditions in most countries have improved sharply in recent weeks, albeit to levels that are still consistent with an ongoing contraction in activity, while indicators of consumer sentiment have also risen. The US Federal Reserve’s business liaison also showed some signs of
stabilisation, prompting the FOMC to note following their meeting at the end of the month that “the pace of contraction appears to be somewhat slower”. Also encouragingly was the strengthening in conditions seen in many of Australia’s major trading partners in Asia. This is especially the case for China, where quick and decisive Government stimulus has produced a sequential improvement in activity.

Towards the end of the month, market participants cautiously waited for the results of the US Governments’ “stress tests” of the capital adequacy levels of the largest 19 US banks which were
released in early May. While the results showed that nearly all the banks have enough Tier 1 capital to absorb higher losses under a more adverse economic scenario, just over half of the banks
were seen to require increased common equity of a combined $75 billion. This was in line with results leaked in the lead up to the announcement.

Central banks provided additional support to their economies in an effort to foster these ‘green shoots’. The US Fed extended the range of collateral it would accept under the TALF programme
to include new commercial mortgage backed securities, while the Bank of England increased their Asset Purchase Facility by £50 billion to a total of £125 billion. The ECB cut rates by 25bp at
both their April and May meetings to 1 .00% whilst announcing their plan to undertake purchases of covered euro area bonds, a move akin to the purchase of mortgage backed securities by the
Fed. Meanwhile, central banks in Canada, Sweden, Norway and New Zealand all cut rates further in recent weeks, with all but the Norges Bank stating that they expect rates to stay low for a considerable period time in an effort to talk down longer term interest rates.

Looking ahead, we expect the global data flow to remain relatively resilient over coming months as production, having dropped sharply since the collapse of Lehman’s, realigns itself with demand and fiscal stimulus measures boost consumer activity in the US. However we remain sceptical over whether a more genuine underlying recovery is now in train. For starters the pace of decline in employment remains for now too large to allow for a sustained pick up in consumer activity, while conditions in global credit markets remain vulnerable to negative shocks. We think there are several risks on the horizon which could test the resilience not only of the US and global economies but also financial markets, including the bankruptcy of US auto maker Chrysler, the potential bankruptcy of General Motors and the emergence of a possible influenza pandemic.

In Australia, the Prime Minister and RBA Governor both conceded that the Australian economy is in recession, with the latest RBA forecast showing a contraction in non-farm GDP of 1 1/2% in the year to June before a modest recovery in the latter part of 2009. The weakness in activity is evident in the deterioration in leading indicators of labour demand and a trend increase in unemployment, though statistical problems saw the unemployment rate fall surprisingly in April. More recent monthly data, however, have clearly shown some positives. The trend in consumer spending has improved, with real retail spending rising strongly in the March quarter on the back of fiscal stimulus measures (including the latest $900 in cash payments) and further cuts in interest rates. Furthermore, record lending to 1st
home buyers is now flowing through into a clear rise in housing approvals, a trend we expect to continue over coming months.

On the policy front, the 2009/10 Federal Budget was released in mid May, with the details well-leaked ahead of the announcement. The budget deficit is forecast to blow out significantly owing to a combination of substantially weaker taxation revenues, higher transfer payments as unemployment
rises and further stimulus measures, including spending on large scale infrastructure projects and increased pension payments. On current projections, the Commonwealth Government is expected to be in deficit until 2015-16.

Among the savings initiatives announced was the tightening of eligibility for a range of government payments, including the private health insurance rebate. Concessions on pre-tax superannuation contributions will also be scaled back significantly from 1 July 2009. The Government will halve the
maximum limit on concessional contributions from $100,000 to $50,000 for those aged 50 or more and to $25,000 for younger investors.

Against this back drop, the Reserve Bank left rates on hold in May, noting signs of stabilisation in many economies, particularly China, as well as the improvement seen in financial markets over the month. In their quarterly Statement on Monetary Policy, the Bank forecast that underlying inflation, which remained stubbornly elevated in the March quarter, would slow sharply over the forecast horizon to be below the Bank’s target band in 2011.
This send a clear signal that further rate cuts are possible, even if growth simply evolves as the Bank expects over the period ahead. At a minimum, it indicates that the Bank does not believe they will need to consider increasing interest rates until the very end of 2010 at the earliest. In light of this, while the RBA may be on hold in the near term, we still see the likelihood that rates will be cut further to around 2.50% over the second half of 2009.

We would like to thank Macquarie Funds Group for contributing to part of this presentation

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