QUARTERLY REPORT

Please note that our Market Report contains expressed comments and opinions which are of general nature and are deemed to only represent the personal views of the author, and therefore are not intended to be, nor should they be considered by anyone to represent, personal investment advice. You should not act on the basis of any of the contents of this publication. AUGEO strongly recommend that you seek professional financial advice tailored to your personal investment objkectives from a qualified source.

MARKET REPORT

The questions which are continually being asked by our investor clients are "Are we there yet?" and "Why are markets so volatile?". To answer them, ones needs to understand the forces that influence and dictate the fate of the global ecomony in general and financial markets in particular. The main symptom at this point in time is more political than economic.

Political uncertainty in the developed world remains a major issue for global economic recovery with elections in the US, France, Greece, and Russia (just concluded), and a changing of the guards at the helm of the People’s Communist Party, as China ushers in two new leaders this year in a major transition of power. 2013 will see elections held in Germany and Italy.

With all of the controversy surrounding the recent Russian election and the return of Comrade Putin to the throne, and more of the same expected to take place in Syria and other autocratic parts of the world, leading to more instability and social uprising, it is quite conceivable that the world may be witnessing a new social movement, a kind of a hybrid between the “Occupy” movement and the “Arab Spring” uprisings, becoming the 2013 version of the Peace demonstrations of the sixties, which shaped the social psyche and influenced the political views of the time the world over.

The US

A wild card at present is the US election which raises the possibility of another period of uncertainty due to the national debt ceiling and the inability of the Congress to agree to any plan of action.

With the US economic recovery failing to materialize so far, the best that could be expected is an avoidance of a double-dip recession, whilst the political shenanigans of the upcoming election continue to be played out irresponsibly and at the expense of the country’s economic future. The US is expected to remain economically in limbo until such time that its political leadership for the next 4 years becomes conclusive. It is worth noting that a change of political direction at this stage is likely to generate more uncertainty and plague its economic recovery for at least the next two years.

Europe

The EU growth will remain anaemic, constraint by unrealistic fiscal austerity measures being imposed and unsustainably-high sovereign debt levels. The German insistence of a “one size fits all” economic policy for all EU members will ultimately prove disastrous for the peripheral PIIGS economies. The harsh fiscal restraint measures being imposed on these countries will virtually guarantee a debt default sooner rather than later, with Greece and Portugal being most at risk at this stage.

The European Central Bank will simply not allow Greece to default, which, truth be said, will be the best thing that could happen to it right now: it will allow Greece to start rebuilding its economy and implementing more appropriate fiscal and monetary policies, which will see it painfully but gradually restore economic balance. However, the ECB will have no bar of this, by making sure Greece continues on a path to a slow death with a thousand cuts. Let's be frank here, the other EU members could not care less about Greece, its sovereignty or its people; to them Greece is nothing more than a worthless stone chip, but right now this stone chip is integral to propping up a hugely expensive marble boulder (let's call it the Eurozone), and without this tiny stone chip this boulder risks instability and collapse. So to all of you humanitarians and too-gooders out there who still believe in the human spirit and acts of kindness, this definitely is not the case with Europe.

As expected, the European Central Bank’s attempt of a second quantitative easing does not appear to be generating the required outcome, as blatantly evidenced in the unwillingness of European banks to lend to one another, and their risk-averse approach of re-investing any funds received back into purchasing ECB bonds, hence minimising default risk and capitalising on interest rate differential, yet denying the economy from much needed liquidity. You just get the feeling that the EU is only one headline away from another disaster.

The Middle East

The Arab Spring has entered a more dangerous level with Syria now in full swing of a civil war, exacerbated by a US threat to arm the rebels, and the Syrian regime likely to be forced into election. Elections are also expected this year in both Egypt and Palestine; whilst 2013 will see two other countries in this region (Israel and Iran) go to the polls.

As if to add more friction to a region that knows no peace, tension is escalating between Israel and Iran, with the latter determined to promote its nuclear capabilities and display its nuclear wares, and the former determined to put an end to it before the security risk becomes uncontrollable; such a dangerous confrontation is causing grave concerns to Israel in particular and the world in general. It is no longer a question of whether Israel will take action against Iran, but simply a question of when, with the Israeli Prime Minister currently visiting the US, undoubtedly to seek confirmation and support.

China

Whilst the intention is not to demystify the positive “China story” mantra spun to death by every economist, investment manager and miner over the past decade, acknowledgement and consensus is now clear that the Chinese economy is contracting and will continue to weaken over the short term in the absence of any global economic growth; subsequently, the best outcome that we could possibly hope for is for a soft landing. With a change of leadership this year at the helm of the ruling Communist Party, the risk of a hard landing could result from a potentially more socialist-driven approach, both politically and economically, which sees a substantial scale-back of economic growth being exerted in order to control a rampant inflation and bring back some level of equality and social justice amongst its people, by seeking to peel back some western influences and return China to more communist fundamentals.

Australia

With weakening Chinese demand for our resources, combined with a Dutch-Disease-infection decimating the non-mining sectors of the Australian economy (at least the East Coast part of), the odds are stacked against Australia realistically avoiding a recession of sort, as economic activities worsen and unemployment rises, negatively impacting assets valuation, be it in equities or real estate markets during the second half of 2012. Such risk will be exacerbated further by the fact that Australia currently finds itself in a political vacuum and lacks strong and knowledgeable leadership in its political ranks. The sooner an election is held in Australia the greater the chance that a more capable government, with a strong mandate, can manage the economy more efficiently and the better Australia will be for it.

As we have stated on previous occasions, for conservative investors, 2012 is a year to remain on the sidelines, with an overweight in cash and fixed incomes. However, astute investors with a longer term investment timeframe could seek to capitalise from extreme market volatility and investment uncertainty by opportunistically building a position for future gain.

-------------------------------------------------------------------------------------------------------------------------------------------------

Reforms to start with China's elite - China's political struggle underplayed

The new generation of leaders will have to persuade the rich old guard in the Communist Party that change is good.

It's been called China's equivalent of the State of the Union speech. China's Premier, Wen Jiabao, will stand before the Great Hall of the People on Monday to deliver his "work report", the highlight of the 10-day meeting of about 3000 delegates gathered in Beijing for the National People's Congress (NPC).

He will outline progress on the government's key initiatives and the top priorities for the coming year. For "Grandpa Wen" this year's NPC will offer the lame duck leader a final chance to boast of the government's achievements ahead of the transition which starts later this year to a "fifth generation" of leaders, the much anticipated generational power shift in the leadership of the Communist Party.

While Wen will try to present an image of a "harmonious society" continuing on its path of "peaceful development", the impending baton change in leaders and what that may herald for the country's future will be a dominant issue of discussion among the delegates at a time when calls for a new era of reforms are growing louder.

Wen regularly used his address to the NPC to call for more reforms, but his rhetoric has not been translated into reality amid roadblocks thrown up against change by more conservative and hardline members of the party who prefer the perceived safety of the status quo. However, it is readily obvious that the "state of the union" in China is not as harmonious as Wen and the gathering of party cadres attending the country's rubber stamp "parliament" would like to project. Since the last meeting of the NPC, there have been numerous events that have cast a pall over the path on which China is on.

Weakness in the major Western markets has undermined China's mercantilist model of cheap exports, with sagging demand for exports weighing heavily on the manufacturing industry, which provides a large number of jobs. Many factories are struggling amid rising raw material and labour costs, and as the yuan continues to appreciate. A tightening of monetary policy and credit access, coupled with the gathering slowdown in the property market, have exposed the multiple vulnerabilities of a debt-addicted economy.

The bank lending that serves as the grease for the Chinese growth machine has exposed the country's banks, and ultimately taxpayers, to a potential spike in bad loans to over-leveraged real estate developers and local government financing vehicles that splurged on their favourite vanity projects. The World Bank warned this week that China's development model was "unsustainable" and in need of reforms. The tragic loss of life caused by a crash on the heavily hyped fast rail network near Wenzhou underscored the corruption and shoddy workmanship that has come to symbolise the pell-mell approach to development.

A high profile riot in a small town in Guangdong stood as testament to the simmering tensions across China as anger among ordinary Chinese at forced land acquisitions without proper compensation, government corruption and heavy handed security crackdowns that grind away at the government's vision of a harmonious society. This is not to take away from the achievements that the Communist Party has delivered over the past 30 years. There is no argument that the average Chinese citizen has enjoyed a material improvement in their standard of living over this time.

But there is growing angst among some Chinese citizens that the benefits of the country's development are not being as fairly distributed as they could, but rather they are increasingly being concentrated in the hands of the country's elite, especially those that straddle the nexus of business and politics. Symbolic of this problem in many ways is the NPC itself. Typical at this time are the stories about how the wealth of NPC delegates dwarfs the total wealth of the members of the US Congress.

It's not surprising that there are concerns about the prospects for reform when you have billionaires and millionaires who have benefited from the status quo as members of a body that is supposed to represent all Chinese. Observers could be forgiven for thinking membership of the party and its elite organisations has become a tool for consolidating power, money, property and privilege among an elite few rather than a tool for delivering collective benefits for the hundreds of millions of Chinese who toil away in relative poverty. This NPC will focus delegates' minds on the future, given the impending change of leadership.

Eyes will be closely trained on those politicians aspiring to rise to the top ranks of power in the leadership transition. Here China faces a choice between players like Bo Xilai, the party secretary of Chongqing, best known for his Mao revivalism, preference for more government involvement in business and crackdowns on crime, and Wang Yang, the party chief from Guangdong, who favours a more business-friendly approach based on smaller government. Which officials eventually win the internal fights to secure positions on the party's most powerful committees alongside Xi Jinping and Li Keqiang (the men most likely to become president and premier) will heavily influence the extent and pace of reform.

While Wen is likely to emphasise the commitments the government has made on policies like affordable housing, moves to a more consumer-based economy and pollution and carbon abatement, there is a pressing need for China's leadership to pursue policies that focus more on the quality of growth rather than quantity. That will require a new approach to development and much needed reforms, but reforms produce winners and losers. In the case of China, reforms that focus on underwriting more sustainable growth may see those who have been the winners emerge as losers.

Whether those plugged into the business and political elite will be willing to push for and embrace reforms is questionable. This NPC will, on one hand, focus on the achievements and legacy of the leadership of Premier Wen and President Hu Jintao, while on the other have a firm eye on the future. It is the future path that is more important than the past that can't be changed.

For those delegates who care about a China founded on sustainable and equitable growth, they may want to remember they're attending the National People's Congress, not the National Elite's Congress. Author: Robert Guy

DISCLAIMER: To the extent that any of the content above constitutes advice, it is general advice that has been prepared without reference to your objectives, financial situation or needs. Before acting on any advice, you should consider the appropriateness of the advice and we recommend you obtain appropriate financial and investment advice before making any financial investment decision. To the extent permitted by law, AUGEO Pty Ltd, its directors and authorised representatives accept no liability or responsibility to any persons for any loss which may be incurred or suffered as a result of acting on or refraining from acting as a result of anything contained in this publication.


Political shenanigan in an election year will ensure no enonomic recovery in the US until 2013 | Europe will unwillingly accept its economic reality, Eurozone will face structural change as peripheral countries finally default leaving bond markets in chaos | China will move to slow its economy to avert economic meltdown as export-led recovery fails to materialize. This will impact the resources boom in Australia, lead to higher unemployment and potential recession spurred by weak manufacturing and retail