Morningstar Economic Update

January/February 2010

Outlook for Investment Markets

Growth forecasts for 2010 remain generally positive notwithstanding shorter-term events such as Dubai and Greece's debt woes. Recovery is clearly underway, but economic policies will not be as supportive as they were in 2009, and the bulk of the improvement in asset prices may already be in the bag for the time being.

Australian Cash & Fixed Interest - Review

Short-term interest rates increased over the past quarter, the Reserve Bank having raised the cash rate a further 0.25 percent in December. Ninety-day bank bills at 4.30 percent are about a percentage point higher than last September, just before the Bank set out on its tightening course. Ten-year Commonwealth bond yields have fluctuated from 5.20 - 5.80 percent since mid-2009, and are currently 5.40 percent. Corporate bond yields have continued to fall as the credit crisis has ebbed further. The $A eased back over the past quarter, losing 0.60 percent in overall trade-weighted value, but had appreciated very strongly over the past year, up 27.40 percent in overall value.

Australian Cash & Fixed Interest - Outlook

The Reserve Bank surprised many on 2 February by keeping interest rates on hold, indicating that it wanted to wait and see the impact of the three previous rate rises before moving again. The Bank remains likely to raise interest rates again, and market expectations are for a further two 0.25 percent increases in 2010. Rising short-term rates will make cash more attractive, although the running yields on corporate debt are more attractive still. Higher domestic inflation will however lead to a more challenging environment for bonds than 2009. The $A continues to look overvalued, but given the strong flows into commodities-backed currencies, the association with the rapidly-growing Asian region, and the increasing attraction of rising interest rates, there are few indicators that this is likely to change any time soon. These factors could also take the $A even higher still.

Australian & International Property - Review

The Australian real estate investment trust sector peaked last October after rallying 76.0 percent from the lows of the previous March. The sector has since struggled, weakening in late October, going sideways in November and December, and joining in the worldwide sharemarket weakness in January this year. The upshot is a 1.80 percent loss for the past quarter.

Global property markets were also knocked sideways in January by wider sharemarket weakness, having staged a strong recovery between March and September last year. The benchmark was down 5.40 percent over the past month, prices falling the most in North America, Asia, and the United Kingdom. The earlier strength, however, means that the index is still showing a small positive return of 1.75 percent for the past quarter.

Australian & International Property - Outlook

The evolution of the economy has clearly been very positive for domestic listed property. A large rise in unemployment, increasing vacancies, and setbacks to tenancies have not after all eventuated, unemployment has actually fallen and consumer and business confidence surveys are both at solid levels. Recapitalisation is also well-advanced, and the property trusts' indebtedness levels have fallen. While the restructuring is still not quite complete, the outlook for domestic listed property is certainly considerably brighter than may have seemed possible a year ago.

The prospect of improving global business activity in 2010 makes for a more positive outlook for global property. However, the restructuring process after the credit crisis is significantly less well-advanced than in the local listed property market, and global property markets will still be working through this in 2010 and 2011.

Australian Equities - Review

The local sharemarket has shared the fate of its offshore counterparts, and has weakened since the start of this year. The S&P/ASX200 Accumulation Index fell 7.10 percent over the past month, one of the larger monthly declines among developed economies. The index was down 2.60 percent over the past quarter, the Industrials down 3.20 percent and the Resources one percent.

Australian Equities - Outlook

The Australian economy has come through the global recession with much less damage than originally predicted. Employment growth has been solid (31,400 new jobs in November, another 35,200 in December), and the unemployment rate has fallen to 5.50 percent. There is clearly still a good macroeconomic environment for Australian companies, and stronger balance sheets after recent recapitalisations. 2010 may not, however, be as good a year as 2009. The higher $A will take its toll on exporters' competitiveness and profits, and higher interest rates on businesses more generally. Near-term valuations look expensive, and profits will have to validate those valuations - the performance of the market depends on companies not disappointing earnings expectations.

International Fixed Interest - Review

Global government bond yields moved only marginally over the past quarter as whole, despite
week-to-week moves as investor confidence about the economic outlook waxed and waned. The JP Morgan Index of global government bond prices was almost unchanged (+0.30 percent) for the quarter. Corporate bonds had a mixed quarter. Yields on higher-rated companies stabilised or even rose slightly, while yields on less creditworthy companies continued to decline as the credit crisis abates.

International Fixed Interest - Outlook

Below-trend world growth with no inflationary pressures because of spare productive capacity is a comfortable environment for government bonds. The huge volumes of new government debt would normally send prices down, but demand from risk-averse investors, central banks, and banks building up the liquidity of their balance sheets will absorb much of the new supply. This suggests few sharp rises or falls in bond prices on the horizon. Corporate debt remains more attractive, given the higher running yield and the prospect of a further tightening in credit spreads boosting prices.

International Equities - Review

The strong rally in international shares from March 2009 ran out of steam in January, world shares down 4.40 percent in overseas currency terms for the past month. The preceding rally means that world shares did well over the past year (up 25.30 percent), but the strength of the local currency means that in $A terms world shares were down 4.50 percent. The S&P500 Index was down 2.80 percent since the start of the year, the MSCI Europe Index three percent, and Japan's Topix Index one percent lower. The emerging markets were also weak over the past month, the MSCI Emerging Markets Index down 3.80 percent. This recent weakness was because of factors such as the impact on bank shares of limitations on their risk-taking proposed by the Obama administration, unexpectedly poor US labour market news, and the problems of heavily-indebted countries, notably Greece. A further factor was that after having risen strongly on expectations of the credit crisis ending and economic growth resuming, sharemarkets were always likely to pause for confirmation that their optimism is being confirmed by events.

International Equities - Outlook

The global economy is improving, although the prospects vary widely from country to country and region to region. The US is clearly on the mend, annualised GDP growth in the December quarter a strong 5.70 percent. Consumers have increased their spending and consumer confidence is on the rise, exports are going well, and businesses are spending more on equipment. Growth has also been stronger-than-expected in China, which grew by 8.70 percent last year, a little above the official target, and consensus forecasts for Chinese growth remain very strong at 9.70 percent this year and nine percent in 2011. With other large emerging economies such as India also expected to do well, the developing world will make a significant contribution to the global recovery this year. Growth in the Eurozone will be both low and fragile, and vulnerable to economic policy mistakes such as the premature removal of economic stimulus. Overall, the outlook for international shares is for support from a recovering global economy, but the outlooks are diverse for the differing economies and regions.

Performance periods refer to the month and three months to 29 January 2010.