PHAROS ECONOMIC FORUM

Bethany: Welcome to our new format for the PHAROS Economic Forum. In the forum today today we’re going to be getting speakers to talk through various bits of economy and economic markets as per the email we sent out yesterday. I’m going to hand over to Peter who’s our chair and he will be able to introduce our guest speakers for you.

Peter: Thank you. Today’s first speaker is Hugh Giddy who is the senior portfolio manager and head of investment research for Investors Mutual. He co-manages with Anton the main fund and has extensive investment experience in equities spanning 25 years. Prior to IML Hugh worked with the investment team at Orbis Global in London before moving to Sydney to work for Platinum Asset Management and then Perennial Asset Management. Both firms experienced substantial growth during his tenure. In 2007 Hugh founded Cannae Capital Partners which later merged with IML in 2010 with a number of analysts from the Cannae team also joining IML investment team. IML has won several institutional mandates and awards since the merger. Prior to joining the finance industry Hugh gained relevant academic qualifications including a Masters in Philosophy and Economics in 1990 from Cambridge University and prior to that a Bachelor of Economics, honors in Economics and Bachelor of Science Maths. IML is one of our approved funds and it’s welcome to Hugh.

Hugh: Thank you and welcome everybody. I’m going to talk a little bit about our outlook and how it’s position to deal with outlook. Looking back the last 12 months what you can see is a very large divergence in the returns of the different securities in the ASX. Obviously some are very high returning, some of these could be very cheap stocks that just happened to go up a few cents but you can see a big dispersion in those 12 months for a lot of stocks. That has been the sign of a stock picker's market and we think it will continue to be the case where if you are on the right side of things, you pick the right stocks and you’re very selective that will give you a better return than just investing in the index.

Investment Mutual is an investment manager and we think a value manager should offer certain characteristics. Obviously we’re looking for growth over time but we are keeping down resilience. When markets are a bit nervous we fall less than the overall

market and that downside prediction is a key feature of Investment Mutual and we’ve exhibited that for many years. Over all periods we show that downside protection and lower volatility and less volatility means a smoother ride for your clients. We also have a largely consistent income and that income is usually franked for tax effectiveness. We have low turnover rates as well which means fewer realised capital gains compared to other managers.

So where are we today? As we look around the world we see a number of headwinds for growth and since the GFC there have been a great number of disappointments in growth. The IMF the OCD and all organisations like the Central Bank keep downgrading their growth forecasts and you think how are these supposedly intelligent consistently wrong? I think it’s because they might have an optimistic bias and that’s a nice thing but it’s been wrong since the GFC. I think also that people think the recovery will be like past recoveries which tend to be more robust than what we’ve had. I’ve written a piece we’ve called ‘Market Musings’ and it’s entitled ‘Sustained Sluggishness.’ If you go to the Invested Mutual website you can get a copy or I’m sure we can send one to you explaining why we believe that the slow sluggish recovery has happened and will continue to be the case. Also why we won’t get acceleration in growth and why growth will continue to disappoint and why therefore you should be selective in your share holding choices. The reasons behind that sluggishness as I explain are a lot of leverage and a lot of debt, most of you know about that but it’s actually frightening how much debt we have.

The population is aging, that’s etched in stone and not something you can wave a wand over and change. The elderly tend to be more restrained in their income and have lesser spending than young people and so as the population ages you’re putting constraints on growth. You’ve got the US economy expanding, again disappointingly and Japan and Europe are pretty more about it. China’s slowing down which is not a help because China’s a pretty large economy and very relevant for Australia. In amongst all of this because of the very slow growth and a lack of inflation because you’ve got a lot of supply of most things interest rates are very low and indeed in most cases they are negative in Europe and Japan. You’ve got quite a lot of negative interest rates which is quite unprecedented.

As I’ve mentioned debt has risen very sharply. Since the GFC which was a crisis that was blamed on too much leverage, too many fancy financial instruments and derivatives the debt burden has continued to expand. It’s expanded across all sectors, particular government but every sector within the RCD and the globe; these are figures from McKinsey, have gone up substantially, 57 trillion is an awful lot of money. The growth rates as you can see have been pretty substantial in categories like corporate debt, people think companies have done well with their balance sheets but they haven’t obviously if they’ve grown debt at 6% per annum. Households have grown their debt a

little more slowly, that’s partly the US where a lot of the mortgages were defaulted on. Government debt’s grown very fast because the governments trying to prop up the economy but still not achieving much growth.

China has grown very fast and most people know about the Chinese miracle but not very many people have visited to see the very impressive infrastructure that they’ve built. They’ve invested a lot in property, construction, roads, highways, railways, airports, apartment blocks, hotels and so forth. It looks impressive to the casual observer but when you go there you can’t help but think it’s extraordinary how much has been built but how much more needs to be built and then can the level of growth be sustained given it’s at such a high level already? What we can see is that fixed asset investment, which is property and construction investment has been falling over time and will probably continue to fall. That’s nasty for Australia because investment uses resources such as steel, coal and iron ore, the kind of things that Australia are good at exporting since we’re not very good at exporting manufactured items, we let China do most of that or Bangladesh or Vietnam.

We’ve constructed an index of what’s happened to resource prices and we look at base metals because you can gather a whole series. You can see what was a huge bubble in things like copper, lead, zinc and aluminium which have long price histories and had an extraordinary increase in price since the early 2000’s and have stayed at high prices until recently. Even though it’s had a pullback that has not taken us back to the origin of the bubble and most pullbacks take us back to the origin of their bubble. At Investment Mutual we do tend to be cautious on commodity prices, they are still not low relative to history although they are low relative to recent history. Anyone who is using recent history is just using statistics to prove their own case.

If we look at what happened in Australia during reporting season a lot of things emerged in very slow growth environments, revenue growth is very tough. The banks are going to see bad debts ticking up again and bad debts have driven a lot of the earning growth the banks have earned and the dividend growth they have achieved is now very likely to be hard to achieve as bad debts are ticking up. They’ve got very high dividends and they need to raise more capital to strengthen their balance sheets and so forth. There’s going to be a tendency for bank dividends to be flat or possibly even fall even without a crisis or recession. Resources with the falling commodity prices their costs are down substantially and they’re decreasing their costs which works its way down into the mining services companies and so there’s a very big sector that’s got a very large profit decline. Obviously the weakness of the Aussie dollar is having an effect on some companies and you’ve got the emerging markets running so if you’re exposed to places like Brazil and Russia which have really struggled with the commodity price falls and big currency falls and recession then obviously sales in those markets are weak.

We do find in a very tough environment that you can find quality companies and IML really focuses on quality companies that are reasonably priced. Quality companies are mostly performing quite well in this environment. If you dissect the market you’ll see the overall markets gone backwards for the year which we’ve almost finished. The market will be down about 5% or a little bit more than that because these are analyst expectations and they are happy optimistic people. Normally industrials will be up maybe 5-6%, financials up 4% with a very low interest rate environment and resources down a whopping 64%. So what does a value manager deliver? Downside protection and so forth but also income. There’s a selection of companies that we own that have all increased their dividends in the current reporting season. There is BHP, our former largest company, not much any more with the commodity price falls it had to cut its dividend by 72%. Comm Bank which is still doing quite well with more shares and some headwinds is keeping its dividends flat. If you’re looking for dividends you certainly shouldn’t have to get caught by the banks and buying high yielding stocks where they can’t sustain their yield because their earnings are collapsing.

So what kind of stocks do we invest in? There’s a case study, we invest in Steadfast which is an insurance broking group, they’re the largest insurance broker in Australia and arrange insurance for small businesses that are in regional areas and centres, it’s not arranging business for say BHP, they can use global insurance brokers. They ensure the best rates and adequate coverage for their customers, they are consolidating their industry and are able to do very useful acquisitions and have very good IT. We find them to be reasonably priced for yield and a very good company with recurring earnings, that is the sort of thing we look for. Our fund as you can imagine has been wary of the material stocks as we’ve seen that bubble in commodity prices and so the material sector is underweight. We’re also underweight in the financials because we have been seeing the uptick in bad debts which have been at very low levels because of rise backs of debt provisions because of the GFC. Where we’re overweight is things like healthcare and utilities which are the quality companies which have recurring earnings, more predictable earnings and are less likely to suffer in a slow growth environment from disappointment over the lack of growth. They have organic drivers that drive earnings performance.

This is a chart showing how our returns have been achieved with very low volatility, our Australian share fund over the last 5 years has had much less volatility than the market or our peer group. It has achieved that lower volatility, the lower downside and that smoother ride for our clients without sacrificing returns because returns have been satisfactory. There’s another chart showing you our downside protection, when the market goes down how long does it take you to get back to where you started? IML is the shaded blue areas and the market is the dotted red line, you can see the market goes down more and therefore takes longer to get back to where you started and get back to square when the market does fall.

Overall we think it’s a market in which you have to be selective, it’s a slow growth market and that lack of growth is likely to persist. We don’t take the passive option of investing in the index, we think we can get decent returns, decent income, good downside protection by investing in an active manager who’s working to achieve things for you. Thanks for your time and here comes the next speaker.

Speaker 1: Thank you Hugh. The second presenter is Clinton Grobler who is the managing investor of PineBridge investment. PineBridge is a product that’s been approved in our alternate space and I’ll hand over to Clinton.

Clinton: Thank you. I appreciate the opportunity to present, we’re obviously new to the APL. We’re a global investment management firm, independently owned. The key part of what we do is a very diverse set of capabilities on the investment side. Page two we take you through the split globally between our AUM and investment capabilities but the product we’re talking about in Australia is the global dynamic allocation fund. Effectively what this fund does is it’s part of our multi asset team and it’s a dynamic asset allocation team that moves between our fixed income equities and our alternatives capabilities and effectively picks asset classes much like you would pick stocks. It is a fundamental platform that is in 18 countries around the world with about 220 investment professionals to serve up into that multi asset product set.

To give you a view of the world we see it’s more optimistic than the previous group but again we’re looking globally and as a dynamic asset allocator we’re looking for pockets of the world where opportunity exists and have the ability to eke out those returns. Our focus is over a 5 year rolling a CPI plus 5 returns, so equity like and we aim to do that across all asset classes over that 5 year period. We do see some emerging fundamental green shoots which support the positive outlook we have in the portfolio that there’s a global growth bounce. Our perspective for us is 5 years which is intermediate term but we do then focus in on the first 9-18 months of that period.

A couple of things we do think speak towards a global growth bounce. Firstly there’s divergence in monetary policies around the the world that will continue to support the dollar. Effectively the biggest input to currency values is interest rate differentials and with some of the major market development blocks obviously adding liquidity to the system whereas the US dollar is at a point where they are looking to reduce liquidity and that should support the dollar over the next 9-18 months. Then there’s a resilience of consumers which we’ve seen particularly in the United States and actually plays out a little bit more broadly in the developed markets and we think that that’s the driver that we’ve been looking for to help pull up the manufacturing downturn that we’ve seen.

Alongside that it’s a commodities supply and demand correction, that we see as some of the issue that’s been riding the markets for the last three months, particularly on the equities side as a risk or stance and we believe that’s been somewhat misread by

extrapolation by the market. This is pretty much par for the course but we can talk to that and it’s really the difference between supply on the oil side which we think is the driver of the last leg down versus the stabilisation of industrial metals pricing which is a little bit more directly related to China versus the oil story. We’ve got to the DMD leverage cycle as far as we can see, fortunately the EM leverage cycle is going to end at some point as well, they’re both going through relative structural changes and we think relative GM to EM, growth market versus the emerging market we are in favour of the DM at this stage.

Conflict is some of the market expectation of reducing some of the ammunition of policy makers. We’re not in this camp, we haven’t been in this camp for the past 6 years but we think that they have all of the tools at their disposal and they are using them particularly the ECB and the BIJ. Negative interest rate policy is the latest, it’s caused some short term misuse in Japan, Europe’s coming through it quite nicely and then the latest announcement from Draghi from the ECB, TLTORP plans to expand out into corporate debt. They are by no means done and by no means out of ammunition and I think you fight them at your peril. Also we do see financing in China and therefor the revival of the industrial orders in China.

One of the things that we think from how we invest on a fundamental basis is growth, however there are also some micro stories that can trump growth. It’s a combination of growth as well as liquidity as drivers. You can see on the page here on the left hand side certainly in the last 3-4 months investors have been completely focused on declining oil and the remmunity value of what’s happening to it as well as what’s happening in China. We already looked at China in two parts last year, the front end from January 2015 through to August was really an undocumented and undisclosed rough landing by China. Here you can see the devaluation and you can see the metals price coming off supporting what was in fact in 2014 some policy errors where they withdrew credit way too quickly and way too sharply. In the end the result is what they saw in the first half of last year. The net result of that is they reengaged in their credit liquidity and you’ve seen turnaround of that coming through in January 2016.

Really now we don’t look at China as an investment led economy, it is a credit fuelled economy and the direct drive into hitting that would be a good credit score we like to watch called Total Credit Financing. That has turned sharply upwards and as a result in China really what they’re working on is slowing down the slowdown. There’s no doubt that the Chinese economy is in slowdown mode, it has to after what they’ve been through but it really is about slowing that slowdwon. There’s some green shoots on the growth side there in terms of the industrial metals sort of plateauing even though oil’s come off so the market is really focusing on oil decline and lock step with equities we think is missing from the bigger picture that’s there.

From a savings perspective this is a longer term chart but really just showing that the central banks have had the bit between the teeth, they are continuing to pump liquidity into the system. The next 9-18 months that is continuing to show some benefit and has helped underpin what has been a slow growth environment but overall keeping that bicycle balanced without having it store speed and then fall over. Another piece to look at would be the EM’s and the DM’s continuing to de-lever. You can see there on the chart on the left the green is the developed markets and here you can see in terms of private non financial credit, it’s really about the consumer, back to the support that we can see is underpinning the consumer continuing to go from strength to strength, they are in much better shape. Yes some of that debt has been transferred onto the public role but from a consumer perspective you need to remember that the US is 70-80% consumer driven. Europe is consumer driven economies so that means that these are the key levers to look at from a growth perspective.

EM unfortunately they’ve continued even without China to add leverage and other than a couple of structural changes and structural success stories in EM pretty much the basket were negative on like India and Mexico. Both of them have gone through some structural requirements and are set up to grown in the post commodity driven world. On the right there it’s back to the story we’ve seen in the US particularly with the strength coming in from the consumer. We see that divergence obviously develop between the consumer and the manufacturer and historically that won’t stay apart for too long. The question was do we see the consumer coming down to meet manufacturing or do we see manufacturing being pulled up to meet the consumer? Our view was there was an overly pessimistic view on growth, particularly when it comes time for manufacturing and effectively that the consumer strength that we’ve talked about would continue. Once you’ve moved through that inventory drawdown cycle which results in equity the main driver for that floor for manufacturing was that had that been completed our thoughts were that manufacturing would pull up. We’ve started to see that in this first quarter of this year.

Instead of global let’s narrow in a little bit and talk about where this positions in the portfolio. We do see improving EBIDTA margins in Europe and Japan, the point here is that Europe’s coming off a very base obviously but that delta on the change does mean that there’s room for the margins to increase. In Japan certainly since 2012-13 which is when we started initiating our position has continued to go from strength to strength. Those improving EBIDTA margins will sort of draft price in that improving fundamental over the short term. Another point on Japan, we talked a little bit about a macro story. Japan slips in and out of growth and recession and is now in slight growth and has for the past 4-5 years. Then everyone decides to throw in the towel and you see big flows out. This is the story we think is really underappreciated in Japan and mirrors a lot what happened in Europe in the early 90’s when they went through their governments revolution.

You can see this earnings per share trend in Japan far outstripping the rest of the world. Really this is about part of our base economic plan and the notion here that they need to take 20 years worth of cash on the balance sheet of these companies and put this back into shareholder hands. You can see this differential on average and the 10 year return on equity. Ultimately things like introducing the new JPY new 400 index is effectively the top half of our earners in Japan get into the index and everybody else loses. The big pension funds have adopted JPY 400 as their benchmark which has set off a national competition in Japan. If you’re not in it then it’s a point of shame, that’s the way Japanese culture works it’s all about a convoy system, if you can get the convoy moving we think that’s going to play out.

That’s the story on Japan and perhaps the thoughts that the central bank, the BOJ is out of ammunition, they are absolutely 100% committed to this and they are looking for inflation for them it’s the only way out. You need to be very careful in thinking that there’s not going to be any more support liquidity put into the system to do that. Negative interest rates certainly in the last 2-3 months has been a negative influence, it’s even made the Yen strengthen which is completely against all of the fundamental underlying drivers. We do believe that ultimately that’s will play out, in the short term the market can have sentiment drive and all sorts of things rule the market but in the end it’s the fundamentals.

Just a quick snapshot on page 10, this is how we build a view of the world, this is our capital markets line. It is effectively a bottoms up fundamental driven way to value all of the asset classes. We put them in a five year forward looking environment of risk, reward and correlation and then we build out what that relative view looks like. You can see the positive correlations we’ve got on the left, European equity, Japanese equity, Mexican equity, Indian equity and on the fixed income side it’s bank loans, European coco bonds and currency wise it’s USD. Even on the right you can see the negative convictions we’re holding. Effectively the slope of that line helps us to determine where we sit from a risk perspective from within the portfolio.

In this case we’ve got a risk rial score up in the corner of 1.8 which means we’re effectively in a risk dial environment. Driving towards 1 would be the most bullish and driving towards 5 would be the most negative where we want to get defensive and really to be able to protect capital. Really it’s about looking at that 5 year forward looking view that we build on a quarterly basis, we keep looking at it and try to determine where the market’s been moved, where value’s been recognised, where it hasn’t and where values continue to deteriorate. Effectively we’re looking to build a portfolio of asset classes that sit above the line, those that are showing very positive and the best risk versus reward traits.

So where do we currently sit at the moment? Effectively you can see the Japanese equity position and European equity position are our big weights. Investment grade US

corporate at 11% however we’ve shorted out the rates with the US government bonds at -10% so that’s a spread there only. Bank loans you can’t see it but US equities has come down from a high of 60% down to around just over 10 and we’ve split in to US value and US small cap. It’s driven by a strong dollar and a slow sustainable recovery in the US which we think will be domestically driven and therefore small cap values are likely to outperform. This is a blend of the portfolios we build and trying to put together those characteristics of growth and defence and look for what regimen we see coming in the next 9-18 months in order to capitalise on that. Thanks very much.

Speaker 1: Thank you Clinton. Our third presenter is Neil Colledge who doesn’t need any introduction. Neil is the senior portfolio manager for Macreon Investment Management and is also the major input manager for proactives. On that score I’ll hand over to Neil.

Neil: Thank you. I’ve been asked to talk about commercial and industrial property. For those of you who are experienced property investors this is going to be pretty basic so please bare with me. We own at present 9 A-Reits of various sorts but we have very little exposure to commercial and industrial property. Why is that? Let’s look at office first. The Australian office market is the biggest property market, much bigger than industrial at about 10 times the size. Most of the value in the office market is in the Sydney and Melbourne CBDs. The other capital city markets are much smaller as are the fringe markets around Australia.

There was a huge number of transactions last year in the Sydney CBD office, almost as big as the previous record year of 2014. As you can see in 2015 Sydney market had a great year, Melbourne pretty good and Brisbane and Perth not so good. If you look at the total return you can see how well it did until the GFC, it was absolutely wonderful and in the 2-4 years since then it’s been recovered. The key factor driving CBD office returns in Sydney in articular and to a lesser degree in Melbourne is foreign investors who have accounted for more than half of total transactions last year. As you can see on the chart this is much bigger than foreign investors have ever been in the past.

Looking at the underlying markets obviously they depend on how well the economies around them are doing. Equally obviously it takes 3-4 years before you get a new office building built in response to increasing demand. If you look at the listing there of listing rates you you can see Sydney is great, Melbourne ok and everything else not so good. Fringe Sydney is variable, some good some bad, fringe Melbourne is ok but once you get outside of those key areas you’re getting vacancy rates in double figures. This is not good if you’re a landlord. The outlook is actually pretty good, mostly because the bad years have gone. What you saw over 2012-14 was the end of the resources boom and the downsizing by the big players, BHP and Rio took up a lot less office and of course the usual solvencies by the small players.

The growth at present is obviously not coming from the mining sector, it’s coming from technology which is hot, education which is hot and professional services broadly seeking. These are not huge space users, there are no giant companies out there but you’re seeing a broad improvement, particularly in Sydney and Melbourne and much less in the resource states. One of the key features for the office market is that thanks to APRA supply is sharply constrained. If you’re a developer you have to get at least 40% of your space pre-committed before a bank will give you finance. This is why we end up with an outlook that is ok but it’s not wonderful and if Australian growth does fall further then the outlook will deteriorate a bit. Again I can’t emphasis too much it’s a question of Sydney good, Melbourne pretty good and the rest fairly unpleasant. In fact if you were listening to the recent half yearly presentations the favourite word by the A-REITS for the office outlook was a challenging environment.

Turning to industrial it’s a much more complex market because it ranges from very high end high tech distribution centres down to very basic elderly office warehouse facilities with a bit of space around for you to park trucks on. Obviously the range in rents for that is huge from say $40 per metre up to $250 per metre. The differentiators asides that are location, obviously some types of facilities such as freight have to be near the airports and seaports that they serve. Distribution facilities on the other hand like Woolwoths, Aldi, Coles and DC’s have to be in outer suburbs near main highways because you don’t want your big trucks driving through city traffic as it slows them down immensely. The other big feature about industrial is that your rents have to be affordable which means you can only put them on areas of low land value. That’s why typically it’s the outer suburbs and typically in areas where governments have made available quite recently as part of their infrastructure build. The only exception to that is inner city Sydney between the CBD and the airport which is quite expensive as industrial goes but it’s mostly high end freight forwarders and other high end users who use that stuff.

Finally one point about industrial tenants, because industrial property is cheap you can always buy it if you’re a major user. You don’t do that if you are someone who wants to move every few years or someone who does not know what their exact needs might be in a couple of years time. I know several companies who have grown spectacularly over 5 years and they’ve outgrown what they thought would last them for a decade, these things happen. It’s always possible for a tenant to become an owner/occupier and the consequence of that means that most tenants don’t stay around whereas retail tenants do stay around.

The asset value of the industrial property market is much smaller and again two thirds of it is in Sydney and Melbourne. Yields are much lower, 6% at best for prime quality. Melbourne and Brisbane rents and capital values have been flat for the last decade, land’s still cheap there. Sydney on the other hand has been picking up strongly in the

last two years and vacancies have been falling quite sharply last year. The drivers of this are all at the high end, this is not in the ordinary suburban factories or the little areas where you have small numbers of industrial users and so forth, it’s at the high end that’s driven by e-commerce and the logistic revolution means you have much larger buildings, you have high tech fitouts for a distribution centre be it a freight forwarder or for a supermarket or other retailer. Because it’s high end the industries that use this have to be high value and most of the activity there besides the obvious tenants of Aldi, Woolworths, Coles are in pharmaceuticals and technology.

What has happened in industrial as I’ve said rents have been flat for a long time but yields on the other hand have been improving. Yields have been improving not because there’s any shortage of property in Melbourne, Melbourne is just an example, but simply because yields have been falling full stop in all bond markets and almost all property markets you’re seeing cap rate compression over the last couple of years. This means if you just sat on the land then suddenly it just got a lot more valuable.

We think the outlook is very much segmented. At the high end for distribution facilities it’s very good. These are relatively few in Australia, there are more and more though just as you will see more and more outsourcing of the supply chain. The outlook for Sydney, the land is much more expensive than Australia which means you have high rents and high costs for facilities which are excellent long term prospects. Melbourne the outlook is pretty good because Melbourne has the biggest manufacturing base and it’s 40% of container freight coming into Australia. The outlook is reasonable but the value up to which you’ve seen up to the last year suggests that prices will rise and supply will increase which is why we’re saying the outlook is ok but it’s very easy to increase supply in Melbourne. The rest no, you’re going to get what you’ve been getting for the last decade because there’s a lot of land and not a lot of growth areas to say you’re going to get stable returns.

As I said at the high end things have been looking great and the one reach which has really taken over the bartering status is Goodman which has done this globally. It’s specialised in producing high end distribution centres and business parks for very large global tenants, not just in the US and Europe but also in China and Japan in particular. It’s done this by partnerships and partnerships account for 90% of its assets under management. 62% of those assets are outside of Australia so this is very much a growth stock, the bad news is it’s priced like a growth stock with a respective yield of 3.5% unfranked which makes it the most expensive trust by a very long way. That’s why we don’t own Goodman, it’s a great company but it’s overpriced.

The reason why we don’t own the other commercial and industrial A-REITS is that the pricing of the whole A-REITS sector is well above NTA. In the case for example Centre Group it’s more than 30% above NTA which is a lot even for flagship malls. For almost all REITS it’s well above NTA and well above the average cap rates. We’re particularly

concerned about the downside risk in office and industrial becuase whereas retail property has fixed rents with increases in specialities and natural catchment areas in the sense that people don’t usually drive very far to go to a shopping centre. For most office and industrial properties most tenants can relocate quickly and easily and you can find your property vacant as well. For us the problems are really the downside risk involved in most office property outside of Sydney and Melbourne’s CBD and the poor prospects of most industrial properties exposure are outside Sydney. We also not as I said that A-REITS are expensive and at the rate they’re going up we may well reduce our exposure to retail A-REITS as well. Thank you very much.

Speaker 1: Thank you Neil for your presentation. It’s now over to people for questions and I might ask the first one. BHP in the last week is up a huge amount, is it sustainable and is it on the back of oil? I know oil prices have gone up so where do we go? I know a client of mine decided to sell at $20.10, we bought in at $15 not that long ago and it’s done nicely.

Neil: Good for that client. Since it’s not yet to give you the happy story that commodity prices are oversold, that oil was hit by an oversupply and that is going to sort itself out and policy makers are smart people who can wisely guide the economy through thick and thin and they can use negative interest rates and everything to make it cheery and so forth. I think that the Cambrian view that dominates a lot of thinking if you go to university and study economics there’s a Cambrian dogma that holds sway in the world that says that government intervention is a good thing and that policy makers of governments know what they are doing and they can guide things along on a good course. I am unfortunately of a somewhat more cautious and skeptical view and I believe that most times governments do something and there’s an unintended consequence.

Negative interest rates for example I think is going to have a terrible effect on savers and retirees of which there are an increasing number will have no income from their safer savings. They will be driven into the market probably at a time when the markets are really quite high. I’m talking most countries, at least the Reserve Bank here has kept some discipline and we do have a positive interest rates. BHP I’ve go no idea where commodity prices are going in the next few days or weeks but overall the share price at $15 was still pricing in higher commodity prices and we have had some of those slightly higher commodity prices. People seem to think that the long term commodity prices will be higher than they are now and if you don’t believe that then you wouldn’t own BHP. It’s a question of what’s going to drive commodity prices higher.

Apparently BHP has got a lot of petroleum sales and a lot of iron ore sales. Oil is a financially traded commodity, it doesn’t really respond to supply and demand although people like to write articles in the newspaper about supply and demand for oil because they like to explain moves. When investor sentiment is positive oil will tend to go up,

certainly if there’s a shortage oil will go up but there’s no real shortage as there’s a lot of oil around, demand is pretty sluggish and over time demand will actually fall because we’re having substitution of other forms of energy. That’s a long term view, that doesn’t mean you’ve got to sell BHP tomorrow, maybe it will rally for another week, maybe it will rally for another five minutes and then fall, I don’t know.

Iron ore would just be a contract between Japanese steel makers and Australian iron ore miners has also become a financially traded commodity. Apparently a billion tons or something like that is traded every day financially which is the total annual consumption. Again iron ore has become a financially traded commodity, there’s been a fall in demand for steel in China, there’s a fall in demand for steel in the rest of the world so in theory Australian miners are producing more iron ore. Classic economics of supply and demand would say that should go down but if there’s financial interests then that creates extra demand which at time will boost the demand for price. We’ve had some very big iron ore price moves that haven’t been driven by demand, it’s more driven by sentiment. If you believe policy makers can wave their wand and make the world grow fast and that will help commodity prices and BHP.

Looking at the commodities more specifically I don’t think they look the most attractive but I’m not a commodity price analyst, I just know that the world to me looks like it’s struggling to grow despite all these supposedly smart people trying their best to get things going.

Speaker 1: How long do you see interest rates staying down at their current levels or lower?

Neil: There’s an easy answer to that, a long time. I do not see interest rates rising in the next few years because I think growth will stay slow and I do not expect inflation to pick up. The only way I think you will get inflation is if the crazies who run the monetary systems start doing things like what’s called ‘helicopter drops’ where they put money into people’s accounts then you’re devaluing money and you’re basically devaluing each currency and then effectively you will have inflation for a while. Possibly dreadful inflation like you had in Germany that actually had the opposite of what people are trying to achieve which is economic growth, they had a transient growth followed by crisis as people needed wheelbarrows of cash to pay for a pint of milk.

Speaker 1: The banks are increasing their bad debts to provisions. What sort of percentage of their overall debt or our overall loan book is that to increase that?

Neil: Bad debt provisions have been in the low teens in terms of basis points of a huge loan book. We’ve been talking 14 basis points, the average for the banks is normally around 25 which is quite a lot more. It varies from bank to bank obviously because they’ve got different exposures, NAB and ANZ tend to have more business exposure which tends to be the one that suffers from bad debts. None of them will look too pretty if we having a

housing price crash but of course that will never happen in Australia because we’re very short of land here and our house prices go up all the time.

Peter: Has it gone from 17 to 21?

Neil: No it’s really ticked up only a little. They are reporting in two weeks time and I think that you will find that the bad debts is going to get some attention because all of our banks have loaned money to Arrium the steelmaker in South Australia that’s insolvent. The receivers have moved in and I think the banks are owed about 200 million dollars each. They can afford that but that’s a bit nasty. Slater and Gordon is likely to go bust, there are a few others Peabody’s there are a few big name exposures which they haven’t had in the last few years.

Speaker 1: I read something in the last few days where they talked about housing but all of the bad stuff was coming out of corporate stuff.

Neil: Yes, when you worry about housing it will be associated. Probably there are two things that could upset housing, one will be unemployment which we’re not really seeing although my guess is that we’ve got lower earning, I wouldn’t say lower quality employment where people get fired from the mines. You were a cook earning a couple of hundred grand and now you’ve got to be a barrister and I don’t think than barristers earn more than 100 grand. The growing part of the economy is resturants and maybe male nursing in a hospital who used to be a truck driver in a mine I don’t think you’d earn the same money. Employment has held up and that keeps the housing market going.

What also would hurt the housing market would be a big downturn in China because although the downturn in China would encourage Chinese to wish to get their money into another country and so forth as we all know there are quite a lot of Chinese people and quite a lot of rich Chinese people too. A downturn would likely be associated with robust capital controls and so forth and possibly they might not be able to invest in Australian apartments like the ones in Barangaroo that were bought off the plan for 2 million apparently for a two bedroom apartment with a nice view, close to the city. It’s a bargain obviously because now that’s it’s been built people are making 3 million and are flipping them for a million more. There’s no bubble like characteristic in a two year 50% gain.

Speaker 1: Any views on the banks and what’s happening there?

Neil: As you’ve said it’s going to get worse. Their bad debt provisions have been far too low for too long. They’re going to rise and that is going to limit their profits and therefore their dividend payouts but you’re not talking about any major catastrophe. The resources exposures received a scare story from Bernsteiner today, so what it’s pretty much in there as everyone knows that the resources exposures are. Your problems are

the unexpected areas such as Arrium which was a long time coming, such as Dick Smith and there will be a bunch more of these. They’re not big, they don’t threaten the banks but it means that they’re going to have to increase their provisions. Commercial is going to get worse in the sense that it’s increasing but it’s not a catastrophic problem. What it is is a constraint on dividend payouts and it means that there’s going to be very little growth in dividends over the next couple of years.

On the domestics of housing as Hugh said what causes housing defaults is when people lose their jobs. When you have a recession that’s when people can’t pay their mortgages. That’s going to happen at some time in Australia, it’s been 25 years since the last one but it’s not on the cards this year, next year maybe. It’s out there but again it’s not catastrophic. We’re not talking about a rerun of the GFC, it’s going to painful but it’s not going to put the banks at risk it simply means that their dividends will not rise and one or two might have to cut them.

Speaker 1: Thanks Neil. I think in terms of summary from the speakers from IMLG was there’s a lot of diversity in terms of performance around individual stocks in the ASX 300 so that’s really critical that you take a good look at which stocks you do follow and industrial seem to be the flavour at the moment. As far as resources from Peter it’s buyer beware, you never know if the resources you choose will stay on course or take a punt and not go in there.

From PineBridge and Clinton the global view is that there are some opportunities out there in terms of taking some positions. I was surprised about the Japan and European team they’re taking, they’re taking those bets based on some economic growth in the low interest environment so we will see how that plays out. As Neil said for the property market, particularly the commercial and industrial you’ve got to be really careful in terms of where you do place your money in the property sector. Commercial seems to be more positive than the industrials but again it’s about picking the right market and the right environment. Anyone who wants to ask further questions just send through a question to the PIC inbox and we will respond. Thank you all.