Investment Market + Portfolio · Investment Market + Portfolio 19 December 2013 Equity prices in Australia, including Financials and Materials, are now fairly priced on a long term

Investment Market + Portfolio 19 December 2013

Equity prices in Australia, including Financials and Materials, are now fairly priced on a long term view and supported by momentum and worldwide low interest rates flow.

International equities, including US equities, are also well supported by momentum and cheap money and they remain attractive relative to bonds.

Increase allocations to Australian equities and (more cautiously) to international equities.

The recent pull back in the Australian equities market has created an opportunity to accumulate growth assets at good prices.

Overall assessment of equity markets

Valuation Momentum Qualitative

Australian equities Fairly priced but slightly cheap Positive Net Positive

International equities Fairly priced but slightly exensive Positive Net positive

Summary

Recommended asset allocation positioning for a three-year horizon

Recommended asset allocation Relative to benchmaRk oR

neutRal:

ZeRo majoR undeRweight

undeRweight neutRal oR benchmaRk

weight

oveRweight majoR oveRweight

Asset class

Cash

Fixed interest tier 1

Fixed interest tier 2

Property & infrastructure

Australian equities

International equities

Alternative equities

Investment Market & Portfolio © November 2013 Madison Financial Group. All rights reserved. 2

Australian investors have earned very good returns from equities over the last year and a half. This is especially so for international equities, given the slide in the Australian dollar against all of the major currencies (with the exception of the Yen which has been pushed down by the advent of new economic and monetary policies in Japan). It has not been a good period in which to hold gold or gold stocks. Cash has offered better returns in Australian dollars than elsewhere, but interest rates are so low that the search for yield continues in earnest.

Table 1: Financial market movements

Where are we now?

Even though some equity markets have drifted lower in recent weeks, they have retained much of the major gains accrued over the last eighteen months. This has been driven mainly by a combination of a vast supply of cheap money worldwide, the earnest pursuit of yield by many investors and the slower than usual but still perceptible economic recovery. Major pitfalls have threatened, such as the US government shutdown earlier this year, but long-term damage arising from these events has generally been averted. Market panics and pullbacks during such episodes have proven so far to be opportunities to accumulate equity assets at favourable prices. The factors which have driven equity markets higher in fits and starts are all still in place.

maRket indicatoR level at 30 june 2012

level at 16 decembeR 2013

movement since the staRt of the 2012/13 financial yeaRs

in local cuRRency in aud

Moreover, the world’s leaders, including the US Congress, appear to be learning how to become adept at averting troublesome situations. The most recent easing back of equity prices looks like another opportunity to accumulate growth assets at good prices.

By comparison, the prospective returns on bonds are not yet attractive enough. We await further increases in bond yields before being tempted. Australian ten year government bond yields would need to be above 5%p.a. to be worth diverting funds from either cash or equities.

s&P asX 200 4080 5090 24.8% 24.8%usa: s&P 500 1329 1786 34.4% 53.2%uk: ftse 100 5493 6522 18.7% 41.3%geRmany: daX 6149 9163 49.0% 85.6%jaPan: nikkei 225 9006 15274 69.6% 48.9%china: hang seng 19447 23191 19.3% 35.9%usd/aud 1.019 0.894 14.0%yen/aud 80.89 92.15 -12.2%euR/aud 0.809 0.650 24.5%gbP/aud 0.653 0.549 19.0%aus: 90 day bank bill % P.a. 3.36 2.64 -0.72aus: 10 yeaR govt bond % P.a. 3.08 4.22 1.14us: fed funds Rate % P.a. 0.15 0.08 -0.07us: 10 yeaR govt bond % P.a. 1.64 2.88 1.24gold usd/ounce 1558 1241 -20.3% -9.2%oil usd/baRRel (wti) 78 97 24.9% 42.3%coPPeR us c PeR lb 340 332 -2.4% 11.3%


Where are we now?

Table 2: Recent conditions affecting financial markets

Region Pluses minuses

usa – Job creation has picked up pushing unemployment to a new post 2008 low

– Quantitative easing has continued at $85 billion per month until now and is set to be tapered slightly to $75 billion per month in January. It has directly supported financial asset prices and will continue to do so for some time

– The Congress appears to have reached a means of passing the federal budget without threatening to close the government or default on its debt

– The growth in services spending is much slower than spending on durable goods.

jaPan – The Tankan surveys of business confidence have picked up across the board. The sentiment for small-scale manufacturers is positive for the first time since 1992.

– The likely increase in sales tax in April may stall the most recent recovery that started about a year ago

china – The recent Third Plenum indicates that the new leadership under President Xi appears to be the strongest in over 30 years and is determined to improve consumer wellbeing

– Increased tension with japan may damage China’s exports

euRoPe – The German government now controls both houses of parliament and is in a position to exert stronger leadership in resolving the European debt and banking crises.

– The EU climb out of recession continues albeit slowly

gReat bRitain – Real economic growth has surprised on the upside (up from +0.6% p.a. to +1.4% p.a.)

austRalia – The Federal deficit will stay larger for longer helping support economic growth

– The fall in the AUD will provide relief to some industries

– There will be some ideologically driven cuts in spending

– Foreign investors appear to be selling Australian equities on a precautionary basis

In summary, recent events are overall more positive than negative for financial markets and in particular for major share markets. Conditions for accumulating equity assets on price weakness are now more favourable than in the recent past.

A more detailed assessment

For most investors, equity investments are a significant part of their portfolio. They are the major driver of long-term returns as well as the cause of short-term volatility in portfolio value. Therefore it is important to carefully assess the attractiveness of equity investment relative to cash, fixed interest and property as well as relative to equity prices over time. Our assessment includes an analysis of:

– The Valuation of equities comparing current prices to long term Fair Prices;

– The Momentum of equity market price movements; and

– Qualitative indicators that take into account the impact of fiscal and monetary policy as well as economic and political factors

In summary our current assessment for the Australian and International equities markets is as follows:

Table 3: Overall assessment of equity markets

Valuation Momentum Qualitative

Australian equities

Fairly priced but slightly cheap

Positive Net Positive

International equities

Fairly priced but slightly exensive

Positive Net positive


Turning to each element of our assessment:

Valuation of equities

Essentially we compare the current pricing of equities in world share markets with an estimate of the Fair Price of each market. The lower the ratio of Current Market Price to the assessed Fair Price, the more attractive investment in particular share market appears. The higher the ratio of Current Market Price to Fair Price, the less attractive or expensive the share market appears.

The Fair Price of an individual stock or of a whole equity market is the price at which the stock or the share market should trade in order to achieve the long term Fair Value Return. The Fair Value Return is the current long-term government bond yield in the investor’s home country plus a margin or Equity Risk Premium that is sufficient to justify the additional risk of investing in the stock or the entire share market. The Equity Risk premium is the extra return that investors demand in order to take the extra risk over and above the guaranteed return on a long-term government bond. Historically, in many developed countries, the Equity Risk premium has averaged about 5% p.a. over long periods of time. In current conditions the ten-year Australian government bond is yielding just over 4% p.a. The Fair Value Return on listed equities for an Australian investor is thus just over 9% p.a. over a ten-year period i.e. 4% p.a. plus 5% p.a. This is the demand side of the investor’s equation.

The supply side is where the returns are coming from. This includes the expected long term return is the current earnings

yield (EY) plus long term growth in earnings per share (EPSG). The Earnings Yield for a particular stock or an entire share market is known. It is the reciprocal of the Price Earnings ratio, a commonly used measure that is the price divided by the earnings per share. The long-term earnings per share growth therefore need to be estimated. Few analysts try to estimate EPS growth (EPSG) beyond the next two to three years, but it is essential to make a long-term estimate.

Once we have done so for a particular stock or an entire share market, we can use the EPS growth rate estimate and our required Fair Value Return to estimate the earnings yield that would apply if the market were currently priced to deliver the required Fair Value Return.

In summary by estimating the long-term EPS growth rate, we can derive the Price Earnings ratio that the market needs to trade at to derive the Fair Value Return i.e. the Bond yield plus our required Equity Risk Premium. We can then compare the actual or current PE ratio with the fair value PE ratio to see how cheap or expensive the market is relative to our required long term Fair Value Return.

We have made assessments of the Current PE to the Fair Price PE for a range of international equities markets as well as the major sectors of the Australian Equities market to see where good or bad value lies. We have made these assessments under three distinctly different scenarios to see how sensitive the results are to different conditions to the assumptions made.


Red = Expensive Purple = Fair Value Green = Cheap

scenaRio one : slow gRowth two : fasteR RecoveRy thRee: RelaPse into Recession PRobability of scenaRio 40% 20% 25%ePs and ePs gRowth assumPtionscuRRent ePs changed by 0.0% 5.0% -15.0%long teRm ePs gRowth Rate changed by 0.0% 0.2% -1.5%

countRy Ratio of cuRRent maRket value to long teRm faiR

value %

Ratio of cuRRent maRket value to long teRm faiR

value %

Ratio of cuRRent maRket value to long teRm faiR value

%

Table 4: Current Price to Fair Price assessments for the Australian equity market.

It is worthy of note that except in the recession scenario, the ASX 200 and most of its sectors are fairly priced and financials appear to be slightly cheap at current prices. The latter includes insurers as well as the big banks. This assessment is based on an average long term EPS growth assumption of 3.5% p.a.

AustraliaASX 200 92% 97% 120%

ASX Midcap 50 95% 101% 125%ASX Small Ordinaries 98% 101% 125%ASX sectors ASX Financials ex AREITS 84% 89% 110%ASX AREITS 97% 103% 128%ASX Materials 105% 109% 135%ASX Energy 110% 114% 142%ASX Industrial 94% 99% 123%ASX Consumer discretionary 107% 113% 140%ASX Consumer staples 111% 118% 146%ASX Healthcare 95% 101% 125%ASX Information Technology 180% 190% 235%ASX Telecoms 96% 102% 126%ASX Utilities 105% 111% 137%


The major item of note is that except in the Recession scenario, the US equity market does not look very expensive although it is more so than the Australian market. Europe and Britain are slightly more expensive while Japan is expensive under all scenarios.

MoMentuM

Our momentum assessments are done by analysing the pattern of the of change in equity markets over the preceding six months. We have found that these patterns have some correlation with persistent momentum over subsequent twelvemonth periods, when we examine the history of the last


Table 5: Current Price to Fair Price assessments for the International Equity markets.

twenty years. The overall momentum of the Australian equity market is positive having been so over most of the last six months. The major developed international equity markets have overall turned significantly more positive in the course of the last two months.

qualitatiVe factors

As long as there is the prospect of a slow but grinding rise in economic growth and corporate earnings any panic based dips in equity prices will provide opportunities to accumulate stock at attractive prices from a longer-term perspective.

Our assessment of the economic, political and policy backdrop to earnings growth prospects is as follows:

International

USA/ S&P 500 104% 109% 135%

Japan / Nikkei 225 192% 196% 242%

Great Britain / FTSE 100 110% 115% 142%

Eurostoxx 50 112% 117% 145%

China / Hang Seng 65% 69% 85%

scenaRio one : slow gRowth two : fasteR RecoveRy thRee: RelaPse into Recession PRobability of scenaRio 40% 20% 25%ePs and ePs gRowth assumPtionscuRRent ePs changed by 0.0% 5.0% -15.0%long teRm ePs gRowth Rate changed by 0.0% 0.2% -1.5%

countRy Ratio of cuRRent maRket value to long teRm faiR

value %


value %


value %

Red = Expensive Purple = Fair Value Green = Cheap


united states of aMerica

– Slower than normal growth but accelerating;

– The major debate over fiscal policy has been deferred till January 2014 but now shows signs of resolution as major participants from the Republicans in the House and the democrats in the senate have reached an agreement in principle to pass a Federal Budget for the first time in years;

– Fiscal Policy is still expansionary but less so with the deficit falling significantly from 10% of GDP to 5% of GDP;

– Monetary policy is still very expansionary with the rate of Quantitative Easing (money creation via bond buying) being trimmed only slightly from $85 billion per month to $75 billion per month;

– The Federal Reserve has essentially committed to keeping short interest rates low for next 3 to 5 years at sub 1% p.a.;

– Long term bond yields are expected to be below 4% p.a. for next three years but then should move up from below 3%p.a. to above 4% p.a.;

– Following recent gains US equities are now slightly into the expensive range above fairly priced but not overly so;

– The Federal Reserve is forecasting real GDP growth to pick up enough to push unemployment down to below 6% by the end of 2015 with inflation still under control at 2% p.a. or lower. In this circumstance the neutral setting of interest rates may be 3% p.a. or lower rather than the historical average of 4% p.a. This would provide a more favourable than expected environment for corporate earnings growth as well as equity market prices. We should however bear in mind that economic forecasts are difficult to get right even when done by well-resourced organisations such as the Federal Reserve;

– The inflationary environment is likely to be broadly supportive of corporate earnings growth, averaging between 1% and 3% p.a. with some potential to surprise on the downside in the next five years and then on the upside after that;

– Overall, the impact of sentiment, as indicated by the PE ratios, will be critical. The continuation of very loose monetary policy will in turn be critical over the next few years in supporting the momentum;

– All of this suggests that while the valuation indicators are not too expensive and momentum is supportive at the moment, caution should be exercised when considering whether to be overweight US equities. It would be better to wait till US equities ease back a little to around 1700 on the S&P 500.

Japan

– Growth has strengthened and appears to be continuing;

– Government resolve to boost growth is stronger than at any time in many years;

– Fiscal policy is expansionary but may be less so if increase in sales taxes goes ahead as planned in April 2014;

– Monetary policy extremely expansionary, more so than in the USA;

– Short interest rates are expected to be low for the next 3 to 5 years at sub 1% p.a.;

– Long-term bond yields are low and expected to remain so for the next three years. They are then expected to moving up from below 1% p.a. to above 2% p.a. if the government achieves its target of boosting inflation to 2% p.a.;

– Japanese equities are expensive even with better growth prospects factored in;

– Real GDP growth has improved and is now running at 3.6% p.a.;

– The key decision facing the Abe government is whether to lift its sales tax rate from 5% to 10% in two stages over the next year and a half as foreshadowed and indeed supported by most economic commentators who want to see the massive government debt (as a percentage of GDP) reined in via fiscal surpluses. A slower transition to higher tax rates is being argued for by advisers close to Prime Minister Abe as they fear a relapse into recession as happened in the 1990s following earlier tax increases;

– Overall there is still a significant risk of a relapse into recession and deflation, with long term JGB bond yields falling to below 0.5% p.a. over the course of the next two years;

– Repairing the fiscal deficit is critical. The IMF estimates that recent deficits have increased the level of Japanese Government Debt to 250% of GDP. Historically this has been funded by enthusiastic bond buying by the Japanese public. As the public continues to age and spend its appetite for bonds will not keep pace with a continued deficit fuelled increase in debt.

The Global Scorecard: factors affecting financial market returns over the next 3 to 5 years


The Global Scorecard: factors affecting financial market returns over the next 3 to 5 years

europe

– A relapse into recession is still possible with the prospect of deflation and the banking and government debt crisis still needs to be resolved;

– The re-elected German government is now a grand coalition that dominates both houses of parliament and should be in a strong position to address pan European financial problems;

– Fiscal policy is still being tightened across the Eurozone and in Britain and this needs to be eased somewhat if unemployment is to fall from current very high levels;

– Monetary policy is expansionary especially after recent rate cut to record low of 0.25% p.a. but still on balance more constrained than in USA or Britain or Japan;

– Short interest rates are expected to be low for the next 3 to 5 years at sub 1% p.a.;

– Long-term bond yields are expected to be low for the next three years but then moving up by 1% p.a.;

– Equity markets fairly priced in Germany but expensive elsewhere;

peoples’ republic of china

– Real GDP growth is holding above 7.5% p.a.;

– The new leadership under President Xi is consolidating its power more strongly than most of its predecessors and it appears quite determined to effect policy changes that challenge entrenched elites but which benefit the broader middle class and the poor. This should have a long term positive effect on China’s growth and its consumption of iron ore and coal exported from Australia;

– Fiscal policy is still expansionary;

– Monetary policy is slightly restrictive;

– Short interest rates are expected to be up slightly in the year ahead;

– Long term bond yields are expected to rise by 1% p.a. over the next two years;

– Equity markets are cheap but volatile;

australia

– Real GDP growth has been reasonably good by world standards but is now slowing;

– The recently elected government has now forecast continuing large deficits and increases in government debt. It is not yet clear whether there will be major spending cuts starting in 2014 to address the deficits and the debt;

– Until there are such cuts (or increases in taxes), fiscal policy will remain expansive and supportive of the economy;

– Monetary policy bias has shifted from neutral to slightly expansionary and may go further to offset any fiscal contraction or continued exchange rate strength. Meanwhile the RBA is trying to talk the AUD down to USD 0.85 and is being moderately successful;

– Short-term interest rates are expected to be stable to down over the next year but may be back up over 5% p.a. Over the next three years;

– Bond yields are expected to be up from just above 4.0 % p.a. to above 5% p.a. over the next three years;


What may happen next?

The PHAROS Investment Committee meets regularly to review the likely future course of investment markets and the implications for portfolio investment strategy. In doing so it identifies some key variables and attempts to make estimates of how they might move in the future. These are summarised in the table below under the heading Stakes in the Ground.

Table 6: Stakes in the ground

PIC Estimates of key variable in twelve months’ and three years’ time as at mid December 2013. Estimates of the following in twelve months’ and three years’ time.

Variable current leVel

likely leVel in 1 years’ tiMe

range and (consensus)

likely leVel in 3 years’ tiMe

range and (consensus)

Interest rates RBA cash rate % p.a. 2.50 2.00 to 2.50 (2.25) 4.00 to 4.50 (4.00)

6 month TD rate % p.a. 3.75 3.25 to 3.75 (3.50) 4.00 to 6.00 (4.50)

10-year bond yield % p.a. 4.37 4.50 to 5.25 (5.00) 4.00 to 6.00 (5.50)

Stock markets PE of ASX200 16.4x 14x to 18x (17x) 12 x to 16x (15.0x)

ASX 200 index 5144 5000 to 6000 (5700) 5000 to 6800 (5300)

PE of S&P 500 17.0x 12x to 20x (18x) 15x to 18x (16x)

S&P 500 level 1808 1450 to 1900 (1850) 1600 to 2000 (1900)

Other important indicators

Australian dollar AUD USD exchange rate

0.9039 0.82 to 0.92 (0.85) 0.70 to 0.90 (0.75)

Given the dispersal in the range of views, the following is a statement of the consensus.

cash, fixed interest and foreign exchange

Short-term interest rates:

RBA may cut interest rates further towards 2% p.a. particularly if unemployment starts to rise significantly from the current level and consumer spending and confidence remain subdued. Term deposit rates may also continue to fall over the next year.

Bond yields:

Even though the US Federal Reserve will have to eventually taper its bond buying under the QE policy and this may be deferred and than be only gradual over a period of some years, bond yields are more likely to rise than fall thereby steepening the yield curve in the USA, Japan, Europe and Australia. Australian Government Bonds (10 year) will become more attractive, the closer the yield moves towards 5% p.a.

Credit spreads:

In a rising bond yield environment credit spreads are vulnerable to an even greater blow out in yield leading to capital losses. The increase in credit spreads has almost become attractive enough to represent fair value for risk in Tier 2 fixed interest.

Foreign exchange (AUD vs USD in particular):

The AUD is more likely to fall than rise from its current level around USD0.90 plus towards USD0.85 or below. Therefore international equity investment should be unhedged for all risk profiles although as the AUD falls it would warrant a reinstatement of hedging of up to 50% for the more conservative risk profiles.

equities

Earnings per share growth:

Outside of the major miners and energy companies, earnings per share growth is likely to be very modest, including for the major banks i.e. low single digit versus double digit growth of over five years ago.

Market pricing of equities (PE ratios, momentum):

We are in a lower yield/ higher volatility world where we have sustainable yields of 2% p.a. to 3% p.a. on cash and fixed interest and international equities and 4% p.a. to 5 % p.a. on Australian equities, but with the prospect of price volatility of plus or minus 20% on equities in any 6 to 12 month period.


What to do next and why: Investment Portfolio Strategy

Table 6:Recommended asset allocation positioning for a three-year horizon

RecoMMended ASSet AllocAtIon RelAtIve to benchMARk oR neutRAl:

ZeRo MAjoR undeRWeIght

undeRWeIght neutRAl oR benchMARk

WeIght

oveRWeIght MAjoR oveRWeIght

asset class

Cash X

Fixed interest tier 1 X Fixed interest tier 2 X

Property & infrastructure X

Australian equities X

International equities X

Alternative equities X

Changes since last report: Increase in growth or risky assets (Australian equities, International equities, Alternative equities, Fixed

interest tier 2) Reduction in Cash.

There are two main reasons for and one against: The positive factors include the still attractive pricing of equities versus fixed interest and supportive momentum as a result of continued stimulation from very loose monetary policy. The negative factors, which, in our view are outweighed by the positives, relate to the qualitative or hard to quantify factors such as the uncertainty around:

– The risks in the resolution of the US fiscal policy and debt ceiling impasse which appear to have reduced significantly in the last week or so;

– The resolution of the European fiscal and banking crisis, which now has better prospects with a re-elected strong

German government;

– The implementation of the increase in sales tax rates in Japan over the next year or so;

The pricing of stocks in Australia and the USA and parts of Europe is still reasonably attractive relative to the assessment of long-term fair value (see Table 4 later on in this report). In addition the momentum towards equities and away from fixed interest is being supported by low interest rates at the shorter term worldwide, where the major central banks have anchored short rates.

Table 7: Stock Market Investing Limits

Table 7 sets out trigger points for buying and selling various share markets for those who wish to manage portfolios on this basis as an alternative to the approach of setting weightings relative to long term strategic benchmark.

ShARe MARket (And Index) cuRRent level At 16 deceMbeR 2013

AccuMulAte When Index IS beloW

Reduce When Index IS Above

IMPlIed WeIght RelAtIve to benchMARk

Australia (ASX 200) 5090 5422 6235 Overweight

USA (S&P 500) 1786 1735 1995 Benchmark weight

Japan (Nikkei 225) 15286 8777 10093 Underweight

Great Britain (FTSE 100) 6499 5633 6478 Underweight

Eurozone (Eurostoxx50) 2960 2794 3213 Benchmark weight

– Increase the allocation to Australian equities to 65% of the range (i.e. 15% of the range above the benchmark or neutral weight) over the course of the next few months especially if the ASX 200 approaches or goes below 5000,with a focus on increasing mid cap and small cap exposure as well;

– Increase the allocation to International equities to 55% of the range over the course of the next few months especially

if the S&P 500 approaches or goes below 1700,with a focus on increasing allocation to US equities if that occurs;

– Maintain current allocation to fixed interest with a view to increasing if yields on offer improve;

– Maintain neutral weight to property and infrastructure.


scenario one: continued slow growth recoVery (35%)

- The USA avoids a return to recession by achieving a solution to the Fiscal impasse in early 2014. There is slower than normal economic growth (below 4% p.a.) during the recovery over the next five years. This means that unemployment will reduce slowly and stay higher than in most previous recoveries. This also means that the Federal Reserve, unless it changes its stated policy under the new chairman, will keep interest rates low for some years to come. It will also decide to taper off its buying of bonds under the quantitative easing program from the newly announced level of $75 billion per month over quite an extended period. It may not end up selling much of the $4 trillion of bonds on its balance sheet prior to maturity over the next ten years;

- Japan achieves low real growth and some modest reforms which assist in limiting the growth of its government debt as a proportion of GDP;

- China continues to achieve growth above 6% p.a. slowing only slightly as they increase the amount of infrastructure investment and also slightly liberalise financial conditions for their major banks while reining in the secondary banking system. This is generally supportive of prices and volumes for Australian commodity exporters;

- Overall, Europe achieves low growth with very low inflation. Inflation in developed countries picks up only slightly into the 2% p.a. to 3% p.a. range from 2014 onwards. This has the beneficial effect of slightly reducing real interest rates and the real burden of debt;

- Australian cash and short term interest rates are stable to slightly lower through 2014 and then increase only modestly by the end of 2015 with the RBA cash rate rising to 4.0% p.a. by then;

- Bond yields have a capacity to rise by between a further +0.5% p.a. and +0.75% p.a. by the end of calendar year 2014 mainly in response to US bond yields rising as QE is tapered by the US Federal Reserve rather than any re-emergence of inflation worries;

- Commercial property values remain fairly static through into late 2014 with rental yields being of prime importance in returns;

- Earnings per share for the ASX 200 grows moderately over the next five years with the exception of the major resource companies which achieve more rapid growth in the next two years and beyond as Chinese growth fears fail to emerge and iron ore and coal prices hold up close to current levels while volumes continue to increase;

- The Australian share market is prone to further falls of between 5% and 10% during the course of the next 6 to 9 months but has a reasonable prospect of being some 10% above its current level by June 2014 and 20% by mid-2015;

- International share markets, led by the US, show some moderate weakness over the next six months (5% to 10%) before resuming their recovery underpinned partly by improved earnings growth;

- The Australian dollar continues to swing in a range of between USD 0.80 and USD 0.95, adding more short term volatility to returns on international assets;

scenario two: faster recoVery (25% probability)

- Worldwide growth is surprisingly stronger than expected due to consumers and businesses recovering in confidence and policy makers avoiding mistakes and convincing their legislatures to back them over the next two to three years. In particular the US Congress agrees to a sustainable medium term plan for dealing with the Federal Budget Deficit. US unemployment drops below 7% by late 2014;

Appendix: Summary of Possible Scenarios

- Europe grows real GDP by 2% p.a. or more over the next two years. European bond yields stay subdued for at least the next year avoiding a stall in the recovery. Japan recovers more quickly and Chinese growth slows only minimally or even accelerates;

- Inflation in developed countries picks up into the 3% p.a. to 5% p.a. range from 2015 onwards but does not get out of control, even though it is at the higher end of the range most of the time;

- Australian cash and short term interest rates increase over the course of 2014 to 5% p.a. or above in order to pre-empt any re-emerging inflation risk;

- Australian bond yields up by between +0.50 % p.a. and +0.75% p.a. by the end of 2014;

- Commercial property values start to recover more quickly starting in mid-2014;

- The Australian share market is prone to falls of between 5% and 10% during the course of the next two financial years but has a reasonable prospect of being some 15% to 20% above its current level by 30 June 2014 and 30% or more by mid-2015;

- International share markets, led by the US, show slight weakness over the next six months (5% to 10%) before resuming their recovery reaching 30% above current levels by 2015, underpinned by better than expected earnings growth;

- The Australian dollar continues to swing in a wider than normal range, adding more short-term volatility to returns on international assets.

scenario three: relapse into recession (25% probability)

- Persistent unemployment in Europe, slow reductions in unemployment in the USA which limit consumer confidence, combined with fiscal policy mistakes in the USA, Britain and Europe and /or Japan drive much of the world back into recession re-emerges by late 2014;

- Inflation is contained by recession and slips into deflation in some countries for up to 5 years;

- Australian cash and short term interest rates down by 1.0% p.a. from current levels by the end of financial year 2013-14 as the world moves into recession and the RBA cuts rates to stimulate the economy.

- Australian Ten Year Bond yield down from current level by between 0.5% p.a. and 0.75% p.a. by mid-2014.

- Commercial property values do not resume growth until 2016 or later.

- With the exception of major resource companies and perhaps the major banks, earnings per share growth for the ASX 200 companies are negative in financial year 2013-14 and growing more slowly by 1% p.a. for the next 5 years.

- Australian, European and US stock markets bottom some time in 2014/2015 between 15% and 25% below current levels and recover their current levels in 2017 or later.

The Australian dollar continues to swing in a wider than normal range, adding more short-term volatility to returns on international assets.

The other 15% of possibilities we simply do not know about. They include a range of unknown unknowns or X factors such as the possibility of war between Japan and China or an Israeli pre-emptive strike on Iran.

This document and its contents are general in nature and do not constitute or convey personal advice. It has been prepared without consideration of anyone’s financial situation, needs or financial objectives. Formal advice should be sought before acting on the areas discussed. This document is a private communication and is not intended for public circulation other than to authorised representatives of the Madison Financial Group and their clients. The authors and distributors of this document accept no liability for any loss or damage suffered by any person as a result of that person, or any other person, placing any reliance on the contents of this document.

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Investment Market + Portfolio · Investment Market + Portfolio 19 December 2013 Equity prices in Australia, including Financials and Materials, are now fairly priced on a long term