May 2014 — Over the Horizon Market Commentary by David Offer

Earlier in the month, Australia’s March quarter gross domestic product (GDP) figures were released for the March

quarter. These showed resilient quarterly growth of 1.1% that was ahead of expectations of growth of 0.8%. Annualised

growth for the 12 months to the end of March was 3.5%, a level of growth marginally ahead of Australia’s long term

average of 3.25%.

This favourable headline result was attributed to a surge in mining exports, which otherwise masked a benign domestic

economy. While there was an increase in investment in housing and household spending, capital investment was down

over the year. Consequently, annual unemployment has remained relatively unchanged at 5.8% and inflation has been

contained at 2.8%. Australia’s Reserve Bank of Australia (RBA) interest rate setting of 2.5%, which has remained constant

for the last 9 months, appears likely to continue to remain unchanged for some time to come.

At the current time, there are a number of global issues that point towards economic headwinds for Australia.

The first is that the European Central Bank (ECB) has addressed the issue of a stagnating European economy by cutting

the bank’s key interest rate to 0.15% from 0.25% and dropping its deposit rate (the rate paid to banks who leave cash at

the ECB) to minus 0.10% from zero. Effectively, the ECB is now charging banks to hold money with the ECB and this is

being done in an effort to force banks to lend more to customers. This and other ECB stimulatory measures have created

upwards pressure on the Australian dollar as investors exploit the difference in Central bank interest rate settings. It now

appears likely the Australian dollar is going to remain high for considerable time to come and this is not good news for

Australian exporters.

Next on the list is an increasingly oversupply of housing in China, which is contributing to a lower iron ore price. Recent

research suggests that there are approximately 50 million unoccupied homes across China. While many of these will

gradually fill on the back of government urbanisation polices, it is concerning that up to 25% of these subsidised vacant

houses are owned by high income earners. As these houses can be readily sold, this suggests that Chinese property

prices will remain depressed for some time to come. While affordable housing is one of the Chinese Government’s main

growth-boosting programs for the remainder of this year and next, it is likely housing will not feature as much in the Central

Governments next Five Year Plan that will come into effect in 2016.

With 30% of Australia’s iron ore exports to China utilised within China’s property sector, this helps explain the current

weakness in the iron ore price. However, with RIO Tinto and BHP Billiton arguably the lowest cost producers of iron ore

globally, with a breakeven price for iron ore production of US$43 a tonne and US$50 a tonne respectively, our majors are

well positioned for any downturn. Fortescue Metals is in a less desirable position, with a breakeven cost of US$72 a

tonne. Many of Australia’s smaller iron ore producers have breakeven costs closer to $100 a tonne, and these are the

companies that will be really vulnerable in the event of protracted weakness in the iron ore price.

Another major global headwind is the high oil price due to escalating and tragic civil unrest in Iraq. In addition, the Russian

Ukraine conflict has evolved with Russia no longer supplying gas to Ukraine unless payment is made up-front and at an

inflated price. Should this escalate with Russia ceasing the allowing of gas to transit to Europe via Ukraine, this would put

further upward pressure on energy prices.

Finally, US growth is proving to be weaker than expected with the International Monetary Fund (IMF) cutting its outlook for

U.S. growth in 2014 to 2%, nearly a full percentage point lower than its previous forecast. Reasons behind the cut include

the sluggish start to the year on account of harsh winter weather, tepid demand for exports and a cooling housing market

following an initial recovery post the GFC. More positively, recent economic news including improving homebuilder

confidence, a pick-up in consumer spending and strong job creation in April of 288,000 jobs (dropping the unemployment

rate to 6.3%), suggests that the economic slowdown over the brutal winter may be just a temporary blip.

Against this difficult global backdrop and a benign domestic Australian economy that remains exposed to a likely downturn

in the mining sector as capital expenditure retreats from record levels, it is concerning that Australian household debt has

reached record levels. At $1.8 trillion, it towers over our government debt at $300 billion. A redeeming factor is that 72%

of Australian household debt is owed by the top 40% of high income households, suggesting that Australia’s borrowers

should be reasonably able to manage their debt obligations. Nevertheless, such a high level of borrowing indicates that

Australian consumers, along with our Federal government, have used a lot of ‘spending ammunition’ to deal with any

unforeseen economic shocks or global slowdown.

The majority of Australian household debt has gone into real estate. When comparing Australia’s property prices relative

to income earned, Australia is now the third most expensive property market in the developed world, behind only Belgium

and Canada.

Notwithstanding the above issues and in the absence of investment alternatives, share markets globally have tended to

steadily march higher, led by the US market which is now sitting at a record high of 16,781. However, the higher markets

rise, the greater the risk of a fall or at least a modest pullback. We are comfortable with our increasingly defensive stance

within portfolios.

If you would like to discuss any of the above or would like to discuss any aspect of your portfolio, please do not hesitate to contact our office.

Sincerely

David Offer

AUTHORISED REPRESENTATIVE 259188

Director

HORIZON INVESTMENT SOLUTIONS PTY LTD

SUITE 1, POST OFFICE PLAZA, 153 VICTORIA STREET, BUNBURY WA 6230

T. 08 9791 9188 F. 08 9791 9187

E.david.offer@horizonis.com.au www.horizoninvestmentsolutions.com.au

Horizon Investment Solutions Pty Ltd, ACN 083 142 438, ABN 79 668 035 212, AFSL 405897

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