QIC ABN 95 942 373 762 is a statutory government owned corporation regulated by State Government legislation pertaining to government owned corporations. The Corporations Act 2001 does not apply to QIC and, therefore, QIC does not hold an Australian financial services licence and the financial product disclosure provisions in the Corporations Act 2001 do not apply to QIC. However, the Corporations Act 2001 does apply to QIC’s wholly-owned subsidiaries. Where required, QIC’s subsidiaries have obtained an Australian financial services licence. QIC and its subsidiaries and associated entities, and their directors, employees and representatives (“the QIC Parties”) do not warrant the accuracy or completeness of the information contained inthis document (“the Information”). To the extent permitted by law, the QIC Parties disclaim all responsibility and liability for any loss or damage of any nature whatsoever which may be suffered by any person directly or indirectly through relying on the Information, whether that loss or damage is caused by any fault or negligence of the QIC Parties or otherwise. The Information is not intended to constitute advice and persons should seek professional advice before relying on the Information.
Investment Markets – 2007/08Doug McTaggartAugust 2007
2
Agenda
- What I said last year (July 2006)
- Market performance over 2006/07
- Prospects going forward
- Key risks
- Conclusions
3
Conclusions – driving forces (July 2006)
- Inflation appears to be under control
• downward pressure on prices from foreign imports
• upward pressure from AUD a complication
- Interest rates will benefit from continued low inflation
• economic growth will determine cyclical pressure on rates
- As for economic growth
• long run trend growth looks good
∗ low inflation, low interest rates, high productivity
• short run cyclical downturn led by the US likely
4
Conclusions – implications for assets (July 2006)
- The environment is favourable for growth assets
• shares, property, infrastructure, private equity
- But short-run volatility likely when at turning points of cycles
- High-beta assets could suffer the most
• emerging market shares and debt
• commodities
- Expect normal return of assets – say 8.5% on shares and 5.5% on bonds – except if something happens to alter this outcome
5
Market returns – one and three years
Asset class returns to June 30
-15%
-5%
5%
15%
25%
35%
45%
Cas
h
Aus
t Fix
edIn
tere
st
Aus
t Cre
dit
Aus
t Equ
ities
Larg
e C
aps
Smal
l Cap
s
Glo
bal C
redi
t
Int'l
Fix
edIn
tere
st (U
H)
Int'l
Fix
edIn
tere
st (H
)
Prop
erty
Secu
ritie
s
Int'l
Equ
ities
(UH
)
Int'l
Equ
ities
(H)
Prop
erty
(FSW
DPI
)
Int'l
Sm
all
Com
pani
es
per c
ent p
er y
ear
FYTD 3 years
2006/07 was a repeat of the previous three years – an environment favourable to growth assets
Bonds performed less well as interest rates edged up over the latter half of the year
6
Stock markets since 1995
Relative performance of stock markets
0
50
100
150
200
250
300
350
400
30/1
2/94
30/1
2/95
30/1
2/96
30/1
2/97
30/1
2/98
30/1
2/99
30/1
2/00
30/1
2/01
30/1
2/02
30/1
2/03
30/1
2/04
30/1
2/05
30/1
2/06
Jan
1 19
95 =
100
.
S&P 500 FTSE100 ASX200
The Australian stock market didn’t “benefit” from the global equity bubble that started in 1995. And so did not suffer the severity of the subsequent crash
It has, therefore, performed equally well over the longer run
7
Sector performance of S&P/ASX
Australian market indexes
0
100
200
300
400
500
600
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan
1995
= 1
00
Banks Industrials Resources S&P/ASX 200
Banks were the best performing sector up until the early 2000s.
The resources boom on the back of a commodity price boom has seen resource stocks out-perform since 2004
8
A “typical” balanced fund – QIC Growth Fund
Balanced funds returns -- Mercer Pooled Funds Survey(net of fees and taxes)
0
2
4
6
8
10
12
14
16
18
3 months 1 year 3 years 5 years 10 years
per c
ent /
per
cen
t per
yea
r
QIC Competitor median
Funds long equities and other growth assets have done well over the last four years.
But the ten year returns are about what we would expect over the long run – and going forward
9
Markets today
- Markets recently have been more volatile than has been the case
- Factors exercising the mind of market participants are:
• Repricing of risk
• A potential liquidity squeeze, on the back the US sub-prime mortgage debacle
• Contagion from the US housing market to the broader economy
• Sustainability of corporate earnings
• Strong global growth fuelling rising inflation
• Capacity constraints adding to inflationary pressures
• Unwinding of “global imbalances”
10
What determines the value of shares?
- Put simply – the value of the underlying companies determines fundamental value
- And this is determined by the value of their corporate earnings
- And this is determined, on average, by the underlying strength of the economy
- Where share prices go tomorrow depends on today’s share price relative to fundamental value
11
Stock market indexes and EPS
Earnings per share and share prices
0
200
400
600
800
1000
1200
1400
1600
1800
Jan-
79
Jan-
81
Jan-
83
Jan-
85
Jan-
87
Jan-
89
Jan-
91
Jan-
93
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
S&P
500
0
20
40
60
80
100
120
Earn
ings
per
sha
re
S&P 500 12m th forw ard earnings per share
Not surprisingly, therefore, there is a high correlation between measures of earnings per share (EPS) and market values
12
So, the future of stock prices depends on …
- Where∗ future real GDP growth
∗ future inflation
∗ future interest rates
all go
- and on where they are now ∗ i.e. current valuations
- Get these right and the rest is easy!!
13
Real global growth
World GDP growth(PPP and MER)
0
1
2
3
4
5
6
7
8
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
per c
ent p
er y
ear
2000 $US -- World Bank 2000 PPP -- World Bank Real PPP -- IMF Real MER -- IMF
Global growth is strong, though not a record levels
The presence of the emerging economies is finally being reflected in the data
14
The global growth engine – Anglo economies
Real GDP growth per year
-4
-2
0
2
4
6
8
10
Mar-80
Mar-82
Mar-84
Mar-86
Mar-88
Mar-90
Mar-92
Mar-94
Mar-96
Mar-98
Mar-00
Mar-02
Mar-04
Mar-06
Mar-08
% p
er y
ear
.
United States United Kingdom Canada Australia
??However, the engine of global growth remains the Anglo-economies
Of these, the US is the “locomotive
It would seem that the engine economies have passed through the trough in a typical business cycle and an expansionary phase has been entered
15
Conclusions on growth
- Global growth is strong, with emerging economies – China and India – contributing
- The Anglo business cycle is entering an expansionary phase- In the US
• Consumption is holding
• Business investment, ex housing, is recovering
• Housing remain weak (as it does in Australia)
• The labour market remains firm
• Leading indicators point to future expansion
- Europe and Japan also are adding to global growth, for a change- In Australia consumption, investment and the labour market all
appear to be robust
16
What about inflation?
Inflation
-1
0
1
1
2
2
3
3
4
4
Sep-98
Mar-99
Sep-99
Mar-00
Sep-00
Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
per c
ent p
er q
uart
er
Headline inflation (Q)
GST spike
The recent up-tick in the June quarter inflation number was enough to cause the RBA to raise cash rates again, to 6.5%
17
But annual headline inflation is still falling
Inflation
-1
0
1
2
3
4
5
6
7
8
9
Sep-98
Mar-99
Sep-99
Mar-00
Sep-00
Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
per c
ent p
er y
ear
Headline inflation (A)
But the previous June quarter had an even bigger up-tick so, annualised, inflation is falling!
18
Less volatile measures also within ranges
Inflation
-1
0
1
2
3
4
5
6
7
8
9
Sep-98
Mar-99
Sep-99
Mar-00
Sep-00
Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
per c
ent p
er y
ear
Headline inflation (A) Excluding volatile items
Excluding “volatile”components sees underlying inflation more stable and within the RBA’s target zone
One could make the case that the less volatile measure is edging up
19
All volatility in inflation due the other factors
Inflation
-1
0
1
2
3
4
5
6
7
8
9
Sep-98
Mar-99
Sep-99
Mar-00
Sep-00
Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Sep-04
Mar-05
Sep-05
Mar-06
Sep-06
Mar-07
Sep-07
per c
ent p
er y
ear
Tradeable goods Non-tradeable goods
Non-traded goods inflation, while above range, is steadily falling
All the recent volatility in headline inflation is due the traded goods inflation –affected by foreign goods prices and the exchange rate – not the RBA
20
What about valuations?
US Forward PE
5
10
15
20
25
30
Jan-79 Jan-84 Jan-89 Jan-94 Jan-99 Jan-04 Jan-09
RAW FWD PE Trend FWD PE
US PEs are back at long run averages following the equity bubble impacts from 1995 to 2003
Trend PEs above raw PEs indicate a downgrading of future earnings forecasts
21
What about valuations?
US BY/EY
0.4
0.6
0.8
1.0
1.2
1.4
1.6
Jan-79 Jan-84 Jan-89 Jan-94 Jan-99 Jan-04 Jan-09
BY/EY LR average 2 sd
Equities do not look expensive relative to bonds
22
What about valuations?
Australia Forward PE
5
10
15
20
Dec-86 Dec-89 Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07
RAW FWD PE Trend FWD PE
A similar story for Australia, although valuations based on past earnings growth look more stretched here
23
What about valuations?
Australia BY/EY
0.5
1.0
1.5
2.0
Dec-86 Dec-89 Dec-92 Dec-95 Dec-98 Dec-01 Dec-04 Dec-07
BY/EY LR average 2 sd
Equities look more expensive relative to bonds in Australia
24
What can we conclude?
- Global growth, US growth and local growth all look like holding up, even improving as the Anglo-economies enter into a normal expansionary phase of the business cycle
- Inflation in Australia, and elsewhere looks like it is under control, notwithstanding the pre-emptive moves by the RBA
- Valuations do not look stretched, although equities in Australia may be more fully valued than elsewhere
- All things considered, it remains a good environment for growth assets
25
What about the risks
- US housing and sub-prime markets
- Are current earnings sustainable?
- Collapse of commodity boom
- Australian housing market and housing affordability
- Other risks
26
US house price growth collapse
Price growth for existing houses
-4
-2
0
2
4
6
8
10
12
14
16
Mar
-80
Mar
-82
Mar
-84
Mar
-86
Mar
-88
Mar
-90
Mar
-92
Mar
-94
Mar
-96
Mar
-98
Mar
-00
Mar
-02
Mar
-04
Mar
-06
Mar
-08
per c
ent p
er y
ear
.
United States
The collapse in the growth of house prices has been the trigger for all kinds of concerns, including chatter about the US economy falling into recession
27
But …. put in a broader context
Price growth for existing houses
-20
-10
0
10
20
30
40
Mar
-80
Mar
-82
Mar
-84
Mar
-86
Mar
-88
Mar
-90
Mar
-92
Mar
-94
Mar
-96
Mar
-98
Mar
-00
Mar
-02
Mar
-04
Mar
-06
Mar
-08
per c
ent p
er y
ear
.
United States United Kingdom Australia
The recent US experience is not unusual in a broader context
Australia and the UK went through much bigger house price booms than did the US without the necessity of it “all ending in tears”
We need to find other causes to draw the bow of US recession
28
Delinquencies not beyond expectation
US Mortgage delinquencies
0
2
4
6
8
10
12
14
16
18
Q1 98
Q3 98
Q1 99
Q3 99
Q1 00
Q3 00
Q1 01
Q3 01
Q1 02
Q3 02
Q1 03
Q3 03
Q1 04
Q3 04
Q1 05
Q3 05
Q1 06
Q3 06
Q1 07
Q3 07
Q1 08
per c
ent
Sub-prime Prime
The collapse of US house price growth has certainly focussed attention back on the riskier end of the market
But the sub-prime market is about 15% of the US mortgage market which is about 40% of US bond markets
Roughly 15% of sub-prime mortgages are expected to fail
29
Credit spreads
The concern is that the sub-prime market problems will cause a broader liquidity crunch ringing about a collapse in spending, putting us on the vicious downward spiral into recession
History of US Investment Grade Spreads(on the run index)
20
30
40
50
60
70
80
90
100
110
Oct
-03
Dec
-03
Feb-
04
Apr-
04
Jun-
04
Aug-
04
Oct
-04
Dec
-04
Feb-
05
Apr-
05
Jun-
05
Aug-
05
Oct
-05
Dec
-05
Feb-
06
Apr-
06
Jun-
06
Aug-
06
Oct
-06
Dec
-06
Feb-
07
Apr-
07
Jun-
07
bp s
prea
d to
sw
ap
30
Credit spreads
The concern is that the sub-prime market problems will cause a broader liquidity crunch ringing about a collapse in spending, putting us on the vicious downward spiral into recession
But all we see at the moment is the repricing of risk back to something approaching normal levels
US High Yield Credit Spreads to Treasuries
0
2
4
6
8
10
12
Nov
-85
Nov
-87
Nov
-89
Nov
-91
Nov
-93
Nov
-95
Nov
-97
Nov
-99
Nov
-01
Nov
-03
Nov
-05
(%)
ML High Yield Master less Treasury Master
US Investment Grade Credit Spreads to Treasuries
0
0.5
1
1.5
2
2.5
3
Nov
-85
Nov
-87
Nov
-89
Nov
-91
Nov
-93
Nov
-95
Nov
-97
Nov
-99
Nov
-01
Nov
-03
Nov
-05
(%)
ML Corporate Master less Treasury Master
31
Impacts of re-pricing risk
- Moderately tighter credit conditions – effectively a monetary policy tightening
- A pull-back from financial innovation and financial engineering of financial products, and wash-out of high risk borrowing
- A halt in M&A activity based on leveraging corporate balance sheets – a pullback in private equity activity
- A return to yield and “quality” earnings in stock markets, reversing the drift to value stocks on the hope of public to private buyouts
- Potentially real spending effects as households and corporatesface higher borrowing and debt servicing costs:
• Although the impact of this should be minimal based on the underlying strength of household and corporate balance sheets, coupled with the underlying strength in the labour market
32
Are past earnings growth rates sustainable?
Growth rates of earnings per share
0
20
40
60
80
100
120
Jan-
79
Jan-
81
Jan-
83
Jan-
85
Jan-
87
Jan-
89
Jan-
91
Jan-
93
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
cent
s pe
r sha
re
Forward EPS 6.25% per year growth rate
This gets to the question about current equity valuations, which on the surface look good.
But are they based on unsustainable forecasts of earnings going forward?
On some historical measures, yes.
33
Are past earnings growth rates sustainable?
Growth rates of earnings per share
0
20
40
60
80
100
120
Jan-
79
Jan-
81
Jan-
83
Jan-
85
Jan-
87
Jan-
89
Jan-
91
Jan-
93
Jan-
95
Jan-
97
Jan-
99
Jan-
01
Jan-
03
Jan-
05
Jan-
07
Jan-
09
cent
s pe
r sha
re
Forward EPS 6.25% per year growth rate 8% per year growth rate
But, earnings growth potential also depends on the economic environment of the day
We live in a very good environment which, I think, is here to stay for w while
However, the experience of the past four years is unsustainable
34
What about the commodities boom?
Te rm s of tra de
60
70
80
90
100
110
120
130
Mar
-60
Mar
-63
Mar
-66
Mar
-69
Mar
-72
Mar
-75
Mar
-78
Mar
-81
Mar
-84
Mar
-87
Mar
-90
Mar
-93
Mar
-96
Mar
-99
Mar
-02
Mar
-05
Mar
-08
2004
/05
= 10
The commodities boom is really a price boom, fuelled by lagging global supply against growing global demand, as reflected in the very high TOT
35
Causing a problem for trade balance
Tra de ba la nce a s a sha re of GDP
-6
-4
-2
0
2
4
6
Mar
-60
Mar
-62
Mar
-64
Mar
-66
Mar
-68
Mar
-70
Mar
-72
Mar
-74
Mar
-76
Mar
-78
Mar
-80
Mar
-82
Mar
-84
Mar
-86
Mar
-88
Mar
-90
Mar
-92
Mar
-94
Mar
-96
Mar
-98
Mar
-00
Mar
-02
Mar
-04
Mar
-06
Mar
-08
per c
ent
But it is a two-edged sword
The trade balance has collapsed because of the currently overvalued exchange rate
36
This used to be known as the “Dutch disease”
Tra de ba la nce a nd te rm s of tra de
60
70
80
90
100
110
120
Mar
-80
Mar
-82
Mar
-84
Mar
-86
Mar
-88
Mar
-90
Mar
-92
Mar
-94
Mar
-96
Mar
-98
Mar
-00
Mar
-02
Mar
-04
Mar
-06
Mar
-08
2004
/05
= 10
0
-5.0
-3.0
-1.0
1.0
3.0
5.0
7.0
per c
ent
T e r m s o f trade (LHS) Tr ade balance as a s hare o f GDP (RHS inve r te d )
Every time the TOT improve, the trade balance worsens
This is counterintuitive when one thinks of a commodity boom leading to improved export performance
In fact, the very opposite happens
37
Creating a “two-speed” economy
Growth rates of State and Domestic Final Demand
0
2
4
6
8
10
12
WA QLD AUS VIC SA NSW
per c
ent p
er y
ear
The Dutch disease has created a two-speed economy
A further complication for monetary policy management
38
Is the AUD still a commodity currency?
Commodity prices and the exchange rate
50
70
90
110
130
150
170
190
210
230
Jan-83
Jan-85
Jan-87
Jan-89
Jan-91
Jan-93
Jan-95
Jan-97
Jan-99
Jan-01
Jan-03
Jan-05
Jan-07
2001
/02
= 10
0
0.3
0.5
0.7
0.9
1.1
1.3
USD
per
AU
D
USD commodity price index (LHS) USD/AUD exchange rate (RHS)
When the TOT collapse under the weight of increased global commodity supply, the exchange rate should depreciate, restoring competitiveness to the rest of the Australian economy at the expense of the resource sector
39
And house prices?
Price grow th -- e sta blishe d hom e s
-20
-10
0
10
20
30
40
50
60
Jun-
86
Jun-
87
Jun-
88
Jun-
89
Jun-
90
Jun-
91
Jun-
92
Jun-
93
Jun-
94
Jun-
95
Jun-
96
Jun-
97
Jun-
98
Jun-
99
Jun-
00
Jun-
01
Jun-
02
Jun-
03
Jun-
04
Jun-
05
Jun-
06
Jun-
07
Jun-
08
per c
enr p
er y
ear
Sydne y M e lbourne Br is bane
We have been through an extended house price boom, although nowhere near as strong as in 1987-89
House price growth appears to be recovering and will be further stimulated if equity markets continue to weaken or show increased volatility
40
The average punter is a long-run arbitrager
House and share price indexes
0
100
200
300
400
500
600
Jun-
86
Jun-
87
Jun-
88
Jun-
89
Jun-
90
Jun-
91
Jun-
92
Jun-
93
Jun-
94
Jun-
95
Jun-
96
Jun-
97
Jun-
98
Jun-
99
Jun-
00
Jun-
01
Jun-
02
Jun-
03
Jun-
04
Jun-
05
Jun-
06
Jun-
07
Jun-
08
June
198
6 =
100
Sydney Melbourne Brisbane ASX200
Rotation out of shares into houses
Convergence
Convergence
Rotation out of shares into houses
Investors very sensibly rotate between asset classes as condition in markets varies
41
Housing affordability – been there before!
Housing affordability
80
100
120
140
160
180
200
Mar
-80
Mar
-81
Mar
-82
Mar
-83
Mar
-84
Mar
-85
Mar
-86
Mar
-87
Mar
-88
Mar
-89
Mar
-90
Mar
-91
Mar
-92
Mar
-93
Mar
-94
Mar
-95
Mar
-96
Mar
-97
Mar
-98
Mar
-99
Mar
-00
Mar
-01
Mar
-02
Mar
-03
Mar
-04
Mar
-05
Mar
-06
Mar
-07
Inde
x
15
17
19
21
23
25
27
29
31
Rat
io
Housing affordability index (LHS) Repayment to income ratio (RHS)
Current conditions are the same as following the 1987-89 house price boom
Markets equilibrium conditions will change
42
Other risks
- There are many, too many to mention them all:
- Geopolitical risk
- Oil prices
- Capacity constraints
- China falling over
- Global inflation exported from emerging economies
- Unwinding of global “structural imbalance” – US budget deficit and current account deficit
- US dollar depreciation
- Global household indebtedness
- ……
43
Conclusions
- Global growth is expected to remain firm, or even pick up over the next few years
- Global inflation remain firmly under control, not because central banks are doing a good job but because of the globalisation of the workforce and product markets
- The interest rate cycle will enter an up phase on the back of strong real growth
- All in all, it remains a good environment for growth assets
- However, it is inconceivable that the equity performance of the last four years can be repeated one more year
- The re-pricing of risk will see quality come to the fore
- Nonetheless, there is still the “weight of money” driven by an ageing society looking for assets to own and hold
QIC ABN 95 942 373 762 is a statutory government owned corporation regulated by State Government legislation pertaining to government owned corporations. The Corporations Act 2001 does not apply to QIC and, therefore, QIC does not hold an Australian financial services licence and the financial product disclosure provisions in the Corporations Act 2001 do not apply to QIC. However, the Corporations Act 2001 does apply to QIC’s wholly-owned subsidiaries. Where required, QIC’s subsidiaries have obtained an Australian financial services licence. QIC and its subsidiaries and associated entities, and their directors, employees and representatives (“the QIC Parties”) do not warrant the accuracy or completeness of the information contained inthis document (“the Information”). To the extent permitted by law, the QIC Parties disclaim all responsibility and liability for any loss or damage of any nature whatsoever which may be suffered by any person directly or indirectly through relying on the Information, whether that loss or damage is caused by any fault or negligence of the QIC Parties or otherwise. The Information is not intended to constitute advice and persons should seek professional advice before relying on the Information.
Investment Markets – 2007/08Doug McTaggartAugust 2007