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“The Rebuilding of Global Economies”

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1 “The Rebuilding of Global Economies”
Presenter - Brian Nash Director/Authorised Representative Merlea Investments Pty Ltd Australian Financial Services Licensee No

2 D i s c l a i m e r This presentation has been prepared for the general information of investors and not having regard to any particular person’s investment objectives, financial situation and particular needs. Accordingly, no recipient should rely on any recommendations (whether expressed or implied) contained in this document without having obtained specific advice from their adviser. Brian W. Nash & Merlea Investments make no representation, give no warranty and do not accept responsibility for the accuracy or completeness of any recommendation, information or advice contained herein and Brian W. Nash & Merlea Investments will not be liable to the recipient or any other persons in contract, in tort for negligence or otherwise for any loss or damage arising as a result of the recipient or any other person acting or refraining from acting in reliance on any recommendation, information or advice herein except insofar as any statutory liability cannot be excluded.

3 Some predictions listed in the media to worry about…
Some predictions listed in the media to worry about…. These are examples of negative press that can cause investors to stay on the sidelines and not invest. The Fed to reduce its $85 billion a month liquidity injection within the next 12 months. The much-touted current housing recovery will stall and single home price increases will slow and perhaps even level off. Manufacturing and U.S. exports to slow still further. There will be still be no sustained recovery of jobs over the coming year. The Eurozone sovereign debt crisis will again worsen and the banking system grow more unstable. More economies in the Eurozone will slip into recession, including Denmark and perhaps Sweden. France’s recession will deepen. Germany will block the formation of a bona fide central bank in the Eurozone and the UK will vote to leave the European Union. China’s growth rate will continue to drift lower and it will be forced to devalue its currency, the global currency war, now underway, will intensify. Global trade will continue to decline. Japan’s risky experiment with massive QE and modest fiscal stimulus will prove disastrous to the global economy.

4 Overview: What we know so far
Three months ago we highlighted a ‘three speed’ economic recovery, with emerging markets in the fast lane, the US in the middle lane, and the Eurozone lagging behind in the slow lane. Latest projections show a similar picture, although with some worrying risks on the horizon. In particular, a new headwind is developing in emerging markets where the outlook for both exports and domestic demand is more uncertain now than it was just a few months ago. Headwinds stemming from a slowdown in emerging markets are dragging down global growth prospects. Peripheral Europe is regaining competitiveness, but a lack of substantial reform suggests that some of the progress could be temporary. Risks are building in emerging markets, and central banks are facing a delicate balance between encouraging growth and fostering stable price levels and exchange rates.

5 When economies are recovering, central banks typically start to think about the exit and take the foot off the accelerator Four reasons why we expect central banks to stay easy. Global growth is slow, and unemployment is still high. Inflation is low. The Bank of Japan is being particularly aggressive, which will force other central banks to ease. Central banks don’t want bond yields to jump yet.

6 Outlook for non oil commodities
Demand will remain relatively subdued in 2013, constrained by weak OECD growth and slower Chinese growth. Rising incomes and ongoing urbanisation in the developing world will underpin medium-term demand growth in industrial raw materials. We now expect the food, feedstuffs and beverages (FFB) index to fall by nearly 9% this year (6.6% previously). Nominal commodity prices will remain historically high in , but prices will ease in real terms.

7 Inflation receding worldwide, but still a concern in some developing countries
Soft growth, large output gaps, and high unemployment rates in the past couple of years have significantly reduced price pressures, with the rate of inflation down between 2011 and 2012 in all but one region. This benign state of affairs is likely to continue through 2013, despite worries about the inflationary potential of the massive amounts of liquidity sloshing around the global economy, and despite the recent rise in food prices (which is likely to be temporary). In fact, in the developed world and some emerging regions (notably Asia, the Middle East and Africa), inflation will continue to drift down over the coming year.

8 Central bank near-term bias
Investors are anticipating a tapering of the US Fed’s programme of bond purchases in September. This has led to a back-up in global bond yields. Emerging markets have been badly hit, with sharp increases in yields on both local and hard currency debt. The reigning in of US monetary expansion will be gradual: we do not expect rates to rise until 2015. Even so a gradual tightening of global liquidity will create headwinds for the world economy. Monetary expansion in Japan will provide only a partial offset to US tightening.

9 Continued exchange-rate volatility
If and when global imbalances start to creep up again, surplus countries with fixed exchange rates policies and massive foreign reserve pots are likely to once again come under pressure to change course. But the bottom line - for now - is that the world has decided to agree with the Fed chairman Ben Bernanke that the super-loose monetary policies being followed by Japan, the US, the UK and the rest are not zero sum "beggar-thy-neighbour" policies but "enrich-thy-neighbour" policies which, if successful, will leave everyone better off.

10 America

11 Investors have begun pricing in a tapering of the US Fed’s bond buying programme
Fed forecasts Market consensus We have cut our 2013 economic growth forecast for the US, to 1.6% from 2% following a downward revision to first-quarter output to 1.1%. But growth accelerated to 1.7% in the second quarter, driven by strong consumer spending and a pick-up in business investment. Investors have begun pricing in a tapering of the US Fed’s bond buying programme as early as September. This has pushed up US bond yields: 10-year US Treasury yields have risen from 1.7% in May to 2.8% in mid August. This has triggered a sell-off of risky assets. US GDP growth with forecasts

12 Consumer spending is not as robust as in previous recoveries
Consumer confidence is at a low level (consumer confidence is at a standstill). Consumers appear to be unhappily in debt. Debt levels have increased. Employment growth is improving. The housing market is improving but prices are still low.

13 The Fed has based the implementation of this plan on the U. S
The Fed has based the implementation of this plan on the U.S. emerging in improved shape The fact is that there are still doubts about the real strength of the recovery underway in the U.S. The residential construction sector is showing great strength, though in part this has been supported by very favourable financial conditions that are beginning to reverse. Consumption remains stable. Employment is not showing signs of particularly robust growth. The last round of stimuli helped boost job creation again to around 200,000 new jobs per month, not much more previous periods in which a new round of fiscal stimuli was eventually necessary.

14 The start of a cycle of normalization of financial conditions, with higher interest rates
The last time rates were this high, was in July 2011 when they hit 4.55%. This came on speculation that the Fed would soon reduce its bond purchase program after the bullish June jobs report. Many are concerned that this will me a major headwind to the housing recovery.

15 Manufacturing recovery gains momentum as order growth hits seven-month high
PMI rises to five-month high, signalling moderate growth of manufacturing sector: New orders increase strongly Employment rises for second month running Input price inflation slows

16 Bottom Line for the US Economy
Positives QE to infinity will inflate asset prices. The US Federal Reserve has forecast rates will remain unchanged until at least 2015. In the long term, demographics and returned energy self-sufficiency bode well. Negatives National debt: USD16.5tn and rising; debt to GDP: 106% and rising. This is absurdly unsustainable. QE to infinity promises currency debasement, rising prices and lower discretionary spending. Foreigners are buying fewer, and selling more US Treasury bonds. The debt ceiling “temporarily suspended” plus QE to infinity may result in a currency crisis in a couple of years. We remain in unknown territory Too many people have been unemployed for too long. National banks are holding too much cash. Corporate profits are no longer tied to employment growth.

17 Western Europe

18 Is the Eurozone emerging from the longest recession in decades?
We have raised our 2013 GDP forecast for the euro zone, to -0.5% from -0.8%. Most economies in the currency bloc performed better than expected in the second quarter, led by Germany. We have edged up our 2014 euro zone growth forecast to 0.7%. High unemployment, excessive debt levels and fiscal austerity remain constraints on growth. Having cut its main interest rate by 25 basis points to 0.5% in May, the ECB said that rates would remain at low levels for an extended period. Funding for firms and households in the periphery remains scarce and costly.

19 And restructuring of banks’ balance sheets barely started
Balance sheet obstacles to sustained demand growth mean the EU faces two or three more years of recession and tepid cyclical recovery, even if EU policy makers enact the right measures as fast as their glacial decision-making process allows. The balance sheet recession is caused by excessive leverage: zombie banks throughout the EU, excessive sovereign debt, deficits in the periphery and excessive household indebtedness in many countries. Sovereign debt restructuring by bailing out private creditors will not remain confined to Greece. Cyprus, Portugal and Spain are also at risk. Even Italy’s sovereign creditors are threatened because of the seeming inability of its political institutions to deliver growth-enhancing structural reforms.

20 Eurozone recovery gains momentum with fastest growth for over two years
The euro area’s economic recovery gained momentum in August, with manufacturing and service sector companies reporting the strongest pace of expansion for just over two years. So far, the third quarter is shaping up to be the best that the euro area has seen in terms of business growth since the spring of 2011.

21 “France Is Not Bankrupt” – Really?
France is in recession and has been for almost two years. The number of new industrial plants created by foreigners fell 25% last year, and new job creation fell 53%. French industrial output is still falling, and both the manufacturing and service PMIs are among the worst in Europe — far worse even than those of Italy and Spain, both of which are clearly in financial disarray. The level of French debt is at post-war highs and is beginning to approach that of the peripheral countries. The French unemployment level is at a 15-year high of 11.2% and has risen for 26 consecutive months. French youth unemployment stands at 25.7%.

22 French government spending is already at 56% of GDP, and debt-to-GDP is over 90%.
French pay-as-you-go social welfare system is completely unfunded. The scheme has grown to preposterous proportions. French welfare spending now outstrips the rest of the world by a considerable margin. French tax rates are already among the highest in Europe. At a 75% top tax rate, young entrepreneurs and businesspeople are leaving the country in droves. Like the peripheral Eurozone countries, France has started to run a significant trade deficit.( you cannot reduce your debt and run a trade deficit at the same time). This has been one of the key problems in Greece, Portugal, Spain, and Italy. Restructuring a trade deficit is painful in that it requires either a downward currency adjustment or a reduction in labor costs (or an increase in labor productivity).

23 Europe’s latest unemployment statistics are a horror story
A high unemployment rate of young people, those under the age of 25, is a huge problem in an economy because in the long run, an economy can only grow based on how much the labour force grows, in addition to how productive that labour force is. With Europe, if that many unemployed people are essentially not working, it raises real concerns for us. Countries such as Spain and Greece still have unemployment rates well over 25 per cent. Meanwhile, markets remain focused on the fact that the worst of the European recession appears to have past.

24 Europe Conclusions Positives Negatives
There are signs that the European economy is emerging from recession, but the recovery will be slow and uneven. Cities will generally perform better than average once the recovery takes hold thanks to their strong service sectors and ability to tap into external markets. But the disparity between southern European cities and those elsewhere will widen. Negatives A one-off weather-related rebound (German and French construction picked up after a long, slow, cold winter), as well as a boost in export demand from outside Europe that German manufacturers themselves say probably won’t continue. Credit is still tight, which will constrain business investment, and while consumer spending has picked up a bit, French and German shoppers can’t make up for a lack of demand in countries like Spain, Italy and the Netherlands, which are still in recession. Meanwhile, some 20 million people in the euro zone are still out of a job — a record 12.1%. That’s unlikely to change anytime soon. And of course, there’s still nobody talking about the elephant in the room, which is the fact that the Germans will need to go much further in shifting toward a consumer-spending and higher-income model, even as southern European countries work on reforming their labour markets and trimming their budgets.

25 Asia and China

26 Capital has fled emerging markets
Capital has fled emerging markets since June as investors anticipate less bond-buying by the US Federal Reserve. More episodes of volatility in global capital markets are in prospect and emerging markets with large financing requirements could come under strain. For China following 7.5% Y-on-Y GDP growth in the second quarter, we maintain our 2013 GDP forecast at 7.5%. We expect growth to continue to slow over the medium term. We have made further downgrades to our growth forecasts for the other BRIC economies.

27 Growth in emerging economies has slowed in recent months, while mature economies have performed better Private capital in-flows to EM economies are forecast to fall in 2013 and Market volatility amid concerns about an end to ultra-easy U.S. monetary policy will continue to weigh on flows. Weaker growth in emerging economies contributes to the worsening outlook. Some EM economies seem vulnerable to a retrenchment of foreign capital. Other EMs have become important sources of external financing in the global economy, with EM private out-flows projected to rise to $1 trillion this year.

28 China: A turning point? At a time when the global economy is modestly accelerating, China appears to be faltering. For now, it seems likely that economic growth will decelerate, credit growth will slow down, and the country’s new leadership will try to address fundamental issues in the economy instead of resorting to stimulus. The weakness in economic activity reflects weak overseas demand—especially in Europe—and a slowdown in domestic spending on infrastructure and other forms of investment. For now, it appears likely that the economy will grow slowly, that credit growth will slow down, and that the authorities will seek ways to gradually shift the financial system away from dependence on non-traditional forms of financial intermediation. With over 64 million uninhabited apartments, China's ghost cities are sad, lonely places to live.

29 China has been treading a dangerous path
China doesn’t have to look too far for a cautionary tale. Japan in the late ’80s and early ’90s faced a similar slowdown in economic growth. Like China today, it sought to compensate by first unleashing a flood of credit, creating a real-estate bubble, and then engaging in infrastructure spending on the proverbial bridges to nowhere. But it didn’t work, despite the fact that Japan, like China today, boasted a high savings rate, plenty of fiscal capacity, and little foreign deb.

30 Summary Positives Negatives
The China economy seems to have bottomed out – China's factories have picked up the pace in August, the latest sign that growth might be stabilizing in the world's second-largest economy. The Chinese government has recently announced a series of micro stimulus plans that signify the government has the fiscal and monetary strength both to absorb losses and to stimulate the economy if necessary. The Ministry of Finance decided to reduce the tax burden on small and mini enterprises since August 1, with the tax cut reaching nearly 30 billion RMB annually. China surpassed the US to become the world’s biggest trading nation last year, as measured by the sum of the export and imports of goods, official figures from both countries show. Inflation remained subdued at 2.7%, below the government's annual inflation rate goal of 3.5%. Industrial production and trade figures were also better than expected, adding another positive sign to the mix. Negatives China has been spending the equivalent of over 70% of its GDP in fixed asset investment in order to achieve its growth targets. All this QE (quantitative easing) money has lead to a massive credit inflation bubble in Asia.

31 Australia

32 Australian PMI data for July shows a stumble into the new financial year
Key Findings The recent drop in the Australian dollar appears to have had little real benefit for manufacturers thus far (although many indicated they are hopeful it will do so soon). One third of respondents in July noted extreme weakness in local demand and/or consumer confidence. The seasonally adjusted Australian Industry Group , ‘Performance of Manufacturing Index’ (Australian PMI®) fell by 7.6 points to 42.0 in July 2013.

33 Australia's declining terms of trade means nominal economic growth is very weak.
We would argue that within a year or two China's growth rate will be under 5% (assuming China's leadership is serious about rebalancing). That will cause more red ink spillage for the next budget. If the terms of trade fall back to anywhere near 'normal' levels. It might even mean we should expect real cuts to spending, not just cuts to spending growth plans. Australia will mostly likely walk the path of other major developed economies. That is, keep spending, increase deficits, and let the central bank buy up surplus debt issuance if it comes to that. Source: ABS National Accounts

34 ‘Mining boom’ is shifting gear
The new phase will see lower capital investment in mining but actually more ore being shipped. Natural gas will start increasing strongly in 2015. The value of new resources projects has declined and is forecast to fall hard. In the six months from October 2012 to April 2013, the value of projects at the ‘committed stage’ of development decreased by $799 million. In the past twelve months around $150 billion of projects have either been delayed, cancelled or have had re-assessed. Capital expenditure – intentions FY12/13 and 13/14

35 Structural Change in the Australian Economy
Over time, the structure of the Australian economy has gradually shifted away from agriculture and manufacturing towards services, with the mining industry growing in importance recently. Economic activity has also shifted towards the resource-rich states of Queensland and Western Australia. Changes in the structure of the economy have been driven by a range of factors including rising demand for services, the industrialisation of east Asia, economic reform and technical change. In recent years, the rate of structural change appears to have increased, driven by the rise in resource export prices and mining investment.

36 The USD/AUD exchange rate has fallen to 89 cents, its lowest level since September 2010
The recent depreciation of the Australian dollar will help to improve the competitiveness of Australian exporters and import-competing businesses that have had to contend with an exchange rate above parity for much of the past three years. Less positively, a depreciation in the exchange rate could cause an unwelcome increase in the price of imported consumer and investment goods and therefore in the inflation rate. If consumer inflation starts to accelerate again, this could prompt the Reserve Bank of Australia (RBA) to refrain from further cuts to the official cash rate. The RBA have raised the need for caution in a low-interest rate environment, to avoid an undue lift in debt levels.

37 The RBA Minutes are out and shows a bank in half-easing bias
A set of structural factors at work to boost inflation: Demographics pressuring rents and house prices Asian growth story means high oil and other commodity prices Global pressures to drive global food inflation Infrastructure requirements are boosting utilities and other government taxes and charges Natural disasters pressuring insurance levies. The RBA & Monetary Policy: The RBA describes policy settings as being “modestly accommodative”. RBA’s downgrading of GDP and inflation forecasts points to lower rates ahead. Global uncertainty and market volatility has RBA noting “scope for monetary policy to provide some support to demand, should that prove necessary, especially in light of Europe’s sovereign debt woes”. RBA has used rate cuts as short-term confidence booster in past.

38 The housing market – an improving story?
If we are not very careful, Australia is going to have the mother of all dwelling booms. What we are seeing is a three-pronged boost to prices. First is a dramatic push to lift the demand for dwellings by banks offering cut mortgage rates thanks to Reserve Bank Governor Glenn Stevens. But second, and just as importantly, there is reluctance by banks to fund new supply. In any commodity if you inflate demand and squeeze supply, prices go through the roof. Thirdly taxpayers will subsidise the boom via a massive increase in the use of negative gearing via both personal and superannuation tax breaks. Longer term, that will damage the economy and the Reserve Bank will have to take responsibility for pulling the price boom trigger. The market accepts further interest rate cuts but surely the Reserve Bank board members will now have second thoughts about future cuts. Most of the demand will be from investors, including those using their self-managed funds, plus the Chinese. First home buyers will obviously contribute at the lower end.

39 Major economic and demographic trends over the next two decades will produce opportunities for investors These trends include an ageing ­population, food and water shortages, and the shift in the economic axis from West to East. The ageing population is well-recognised in Australia but it is a global issue. At least an ageing population has predictable needs and aspirations - Health care, assisted accommodation, hearing aids, eye care and orthopaedics industries obvious winners. Each year Sonic Healthcare (SHL) serves more than 75 million patients through referring doctors, hospitals, and community health centres in Australia, the United States, Germany, Belgium, Switzerland, the United Kingdom, Ireland and New Zealand. In the third quarter of 2013, 91% of ResMed’s (RMD) revenues were earned outside of the Asia-Pacific region, and other healthcare companies like Cochlear (COH) could be big winners due to the large portion of sales that occur outside of Australasia. There is a huge choice and finding a winner may require a portfolio of them, but stocks that invest in diagnostics or medical aids have more certainty.

40 Food and water shortages CSIRO identified a mega trend for food and water prices to rise faster than ­average inflation. Food production will need to rise by 70 per cent by to meet global demand. Productive farmland shrinking due to over-cultivation and urbanisation. Food prices in real terms are likely to rise as incomes grow in the developing world and as land is diverted into biofuel production. There are few food or agribusiness stocks left in Australia. Consider Ruralco, a servicer rather than a producer. Alternatively, Incitec Pivot, although it also has an explosives business. Ridley Corporation provides feed supplements or a listed phosphate miner. Nufarm produces crop protection products against weed, pests and disease. Water usage in Australia is tipped to rise 42 per cent by The closest investors can get to water rights is Tandou. Phoslock Water Solutions owns technology that removes algae from water. Regional and sub-regional share of world increase in phosphate fertilizer consumption,

41 West to East By 2025 the Asia Pacific region will not only be bigger than North America and Europe as it is already, but bigger than both combined. The rise of China and India, has already wrought huge change on the Australian economy, boosting income and forcing up the dollar. China’s growth boosted our terms of trade mainly through iron ore prices – which are likely to fall . As China moves into the next stage of its industrial development, its demand for more complex resources will rise i.e. Mineral sands. Zircon and titanium dioxide are consumed in tile manufacture and pigment production respectively. Global zircon demand is 1.5 million tonnes annually, with China consuming 40% of this. Higher urban living standards and larger floor plates will drive higher demand for zircon going forward, Iluka Resources is the global leader in zircon and a major player in the titanium market. Long term price for mineral sands

42 EAST to WEST cont ..Developing countries are expected to grow slightly more than 4 per cent annually in the next six years. Domestic travel and tourism spending (USDbn) A second wave will be tourists as China’s middle class grows. Based on current trends, Chinese residents will be the most common visitor to Australia by 2016. With rising wealth and urbanisation, the middle class in the rest of Asia is increasing exponentially. Coming decades will see over 1 billion people in Asia transition out of poverty and into the middle-income bracket between $US6,000 and $US30,000 per year. This will create opportunities for Australian companies, long used to serving a large middle class. Consumer staples, luxury goods and cars, education, health care, financial services and insurance. International share funds will become more skewed to Asian growth.

43 The big themes to watch (in to 2014) these themes in longer term are positive for equities.
Automotive China and US will account for 60% of global growth. Chinese car firms will come to Europe Rising Chinese wages helps other emerging countries Erosion of economies of scale Mass customisation and shrinking supply chains 3D printing Emerging markets impressive :India closing on Russia Entertainment - It’s all about digital Online video games outstrip boxed games Growth in e-books, e-music far outstrip physical versions Rise of tablets and phones as a companion device to TV IT software and services US leads in cloud, big data, apps. Mobile internet. More mobile web devices than desktops Technology winners e.g. Kenya mobile banking; and losers e.g. bricks and mortar Web no longer a separate place.

44 Where are we in the economic and stock market cycle?
We are in the expansion phase

45 Consumer Expectations: Industrial Production:
Sector Rotation Model Stage: Full Recession Early Recovery Full Recovery Early Recession Consumer Expectations: Reviving Rising Declining Falling Sharply Industrial Production: Bottoming Out Flat Falling Interest Rates: Rising Rapidly Peaking Yield Curve: Normal Normal (Steep) Flattening Out Flat/Inverted

46 Where to Invest in 3rd Quarter 2013
Financial (reduce property trust and bank stocks as they are becoming expensive) Consumer cyclical (reduce exposure durable –non durables) Energy Transport Technology Capital goods Mining Infrastructure

47 Australia faces the challenge of managing prosperity
As for the local Australian economy, it seems to be surviving if somewhat patchy in some areas, it’s the solid performance of the resource sector that is backing it, which is also attracting and generating continued business investment. Conditions in some parts of the economy are likely to remain challenging, with unsettled global conditions, the high Australian dollar, ongoing consumer caution and changes in expenditure patterns all expected to weigh heavily on some sectors. Although unemployment remains within the 5 to 6 per cent range, some economic variables are showing significant changes, which is leading to an increase in unemployment in some sectors of the economy. In particular the sustained high Australian dollar has hurt export competitiveness and dampened the tourism sector.

48 Thank you for your time…

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