The Post GFC Investment Environment

MLC MARKET INSIGHT

09/2010

The post GFC investment environment.

What can history tell us?

A paper that puts the difficult post GFC investment environment into a historical context and highlights investment strategies that can be appropriate.

September 2010

Michael KaragianisAndrew Connors

Investment StrategistInvestment Specialist

MLC Investment ManagementMLC Investment Management

Important Information:

This Information has been provided by MLC Investments Limited (ABN 30 002 641 661), MLC Limited (ABN 90 000 000 402) and MLC Nominees Pty Ltd (ABN 93 002 814 959) as trustee of The Universal Super Scheme (ABN 44 928 361 101), members of the National Group, 105-153 Miller Street NorthSydney 2060.

Any advice in this communication has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on any advice in this communication, consider whether it is appropriate to your objectives, financial situation and needs. You should obtain a Product Disclosure Statement or other disclosure document relating to any financial product issued by MLC Investments Limited (ABN 30 002 641 661), MLC Limited (ABN 90 000 000 402) and MLC Nominees Pty Ltd (ABN 93 002 814 959) as trustee of The Universal Super Scheme (ABN 44 928 361 101), and consider it before making any decision about whether to acquire or continue to hold the product. A copy of the Product Disclosure Statement or other disclosure document is available upon request by phoning the MLC call centre on 132 652 or on our website at

An investment in any product offered by a member company of the National group does not represent a deposit with or a liability of the National Australia Bank Limited ABN 12 004 044 937 or other member company of the National Australia Bank group of companies and is subject to investment risk including possible delays in repayment and loss or income and capital invested. None of the National Australia Bank Limited, MLC Limited, MLC Investments Limited or other member company in the National Australia Bank group of companies guarantees the capital value, payment of income or performance of any financial product referred to in this publication.

Past performance is not a predictor of future performance. The value of an investment may rise or fall with the changes in the market.

Table of Contents

Table of Contents

Summary

Part A - History Doesn’t Repeat, But it Does Rhyme

Great Depressions

Part B - Lessons From History

The importance of crisis response

Example - Sweden a shining light

US – a Swedish or Japanese workout?

Part C - Investment markets and banking crises

Part D – Where to from here?

1.Investing for a “V” shaped Recovery

2.Investing for Deflation

3.Investing for the “muddle through” scenario

a) Dividend Yield vs Capital Gains

b) After-Tax focus

c) Dollar Cost Averaging

d) Diversification

e) Active Management vs Passive Management

f) Absolute Return strategies vs Benchmark Relative investing

Summary

If you ignore history then you’re doomed to make the same mistakes.

The current uncertainty in the global economy is going to be around for a while. This will likely result in greater ongoing financial volatility coupled with more modest investment returns. Risky markets such as equities may be in a consolidationtrend for an extended period of time. Whilst this presents challenges, asinvestors there are strategies which can be pursued which can still seek to deliver returns in such an environment. These include:

1. Diversification
2. Dollar cost averaging
3. Active management
4. Risk aware strategies that focus on the absolute return potential offered by high quality investments
5. Secure and stable income returns from high quality assets including equities

This paper serves to improve awareness that the current market environment, whilst unusual based on positive experience of the past 15 years in Australia, is not unique and that with appropriate investment strategies investors can successfully navigate this period.

The MLC Horizon portfolios:

• Are diversified across 14 asset classes and sub asset classes including overseas investment exposure;
• Include Alternative and Absolute Return strategies such as Insurance Related Investments and multi sector managers;
• Are actively managed using some of the best available managers from around the world;
• Are priced daily meaning your funds are available whenever you want them;
• Are backed by MLC, a highly respected investment manager;
• Have a good long term track record;
• Are robustly tested using sophisticated scenario analysis.

If you would like to discuss the paper further, please call any of our investment specialists listed below.

Andrew Connors (02) 9376 5377John Owen (02) 9936 4590

Natalie Comino (02) 9936 4538Kajanga Kalatunga (02) 9936 4537

Marius Wentzel (02) 9376 4549

Or email us at

Part A - History Doesn’t Repeat, But it Does Rhyme

The recent bout of financial market nervousness serves as a timely reminder to investors of the unusual nature of the challenges facing the global economy and hence investors, in the current cycle. Renewed declines in equity markets of between 10 and 15% from their April 2010 peak to late August 2010 reflect a broader escalation of concern about the next stage of the global economy, as it slowly crawls its way out of the hole left by the Global Financial Crisis (GFC).

Whilst the GFC has in many ways been compared to the Great Depression, at least thus far, it is yet to resemble the magnitude of economic disaster represented by the Great Depression. To put it into context, US GDP growth fell peak to trough by just under 5% through the GFC whilst the Great Depression experienced a peak to trough decline in excess of 25%. Nonetheless, the impact of the GFC on the US and global economies has been particularly severe as has the impact on investor returns. This paper seeks to look at the history of financial and economic crises to ascertain what lessons they may hold for investors in the difficult post-GFC environment.

Peak to trough decline in US GDP – GFC vs Great Depression

Great Depressions

We refer above to the challenging environment produced by the GFC as “unusual” rather than unprecedented, because even a casual look through history shows a surprisingly regular occurrence of similar such crises over the past 100 years or so. Given the wealth of financial crises through history, it could be useful to assess how these crises evolved to get a sense of prospects for the current environment. It is particularly useful to contrast the experience of

crises through history to identify factors that were key in determining the severity, duration and ultimate outcome of these events.

Whilst it is possible to go back as far as the Great Tulip Bubble in 1637 Amsterdam and the South Sea Bubble of 1720 to observe early recorded asset bubbles or mania, we can start the story more recently. A major asset bubble and subsequent banking bust was associated with The Depression of 1893. It afflicted the US economy and followed the great railroad construction bubble of the preceding 10-15 years which saw the creation of an enormous railway network across the US, in the process creating huge speculative wealth.

The bursting of this bubble created a Depression lasting more than 6 years where the unemployment rate was thought to have hovered between 10 and 19%, albeit that there were no reliable statistics at that time. Hundreds of banks, having extended railway construction loans, failed through this period as railroad companies defaulted on their debt. Rural and regional property prices, having been over-inflated by the railway boom, collapsed spreading the impact to the household sector. It wasn’t until 1899 that the crisis ended and conditions returned to something approaching normal.

Curiously,Australia suffered its own Depression, independent of the US experience, at that same time, based on similar railway debt and declining wool incomes.

Only 30 years after the ending of one Depression, the Great Depression of the 1930’s is viewed as the first true global Depression having been triggered by the cataclysmic aftermath of the October 29, 1929 stock market crash. The measured unemployment rate in the US rose to around 25% at its peak in 1932 and remained elevated above 10% for more than a decade. In fact it wasn’t until World War 2 that the US economy saw unemployment levels fall to pre-Depression levels.

The Great Depression was felt globally. Virtually every country was impacted by the collapse in world trade to somewhere between 1/3 and 1/2 of its pre-Depression levels. Australia was one of the most severely affected countries with the unemployment rate reaching 28% in 1932. In fact it averaged above 20% for the first half of the decade and was above 10% at the outbreak of World War 2. Australia’s traumatic experience during the Depression was only exceeded amongst industrialised economies byGermany’s, where the unemployment rate peaked around 30% ahead of the election of the National Socialist Party in 1933.

The specific triggers for the onset of these two major Depressions were very similar as was the evolution of the crises. In each case the key was a significant bubble in financial assets and property, funded by excessive debt provided by the banking sector. As a consequence of the subsequent collapse in asset prices and the exposure of banks to those assets, in each case there was a widespread systemic collapse of the banking system as bank capital was destroyed and depositor wealth wiped out.

In the case of the Great Depression approximately 9,000 banks failed in the US alone through the 1930’s. Without depositor insurance or government compensation at that time, individuals saw their life savings wiped out. By way of comparison, post GFC, the period 2008 to 2010 has seen approximately 274 banks fail in the US, although depositors are largely covered by Federal deposit insurance.

Viewing these major Depressions together it is possible to identify essential ingredients which can turn a common run of the mill asset bubble, bust and resulting recession into worst case

Depression. It the case of the two Depressions mentioned it was the magnitude of banks exposure to the particular asset bubble and the devastation the resulting bust inflicted on the banking sector.

In these pre-World War 2 occurrences, the evidence suggests that the impact of asset busts on banks was particularly severe, with widespread insolvency of banks leading to a loss of lending activity in an economy and widespread destruction of wealth. Importantly, in each case the Government of the day was unable or unwilling to undertake the necessary steps to prevent the cataclysm from enveloping the broader financial system and economy.

Deflation not inflation reigned supreme through these periods and individuals and companies were unable to spend or invest because of financial stress and widespread fear. Once deflation expectations became embedded it became very difficult to produce an economic recovery because the belief that activity and prices would continue to fall in future acted as a powerful disincentive to consume or invest now.

The key focus for investors during these difficult economic periods was not a return on capital but rather a focus on capital preservation.Given the parlous state of banks at the time, capital preservation was often achieved by keeping money “under the bed”, hoarding gold or, by investing in government bonds, although the latter approach failed in certain countries where political collapse resultedin a failure of countries to repay debts. The returns provided from equities were weak or negativefor very long periods of time – in the case of the Great Depression about two decades.

Up until the Global Financial Crisis (GFC) of 2008/09, as investors we haven’t really thought too much about these previous periods of history, their relevance considered only by economic and investment historians. The belief in a more sophisticated global economy and financial system and greater confidence in the management of them had led to widespread complacency and an ignorance of many of the lessons from these extraordinary periods.

These lessons are important to understand however, as it is clear that, far from being infrequent in the modern age, asset bubbles, busts and associated banking crises have been, if anything, even more common in the past 20-30 years. The IMF in fact has identified 124 systemic banking crises in the period from 1970 to 2007, of which 42 are well documented occurring in 37 different countries. Despite this, the experience and lessons of such crises are generally very poorly understood or appreciated.

In part this may be because these crises have often occurred in smaller, more isolated cases than we are seeing with the GFC (eg. Spain 1977, Sweden 1991, Finland 1991). Or they have occurred in emerging economies (eg. Latin America Debt Crisis through the 1970’s and 1980’s, Mexican Peso Crisis 1994, Russian Default Crisis 1998 and, the Asian Financial Crisis 1998), where their relevance for developed economies is considered minor.

However, we have seen asset bubbles and associated banking crises hit closer to home in major developed economies in recent history (eg. US Saving & Loans Crisis 1988, UK 1992, Japan 1997). Of these, undoubtedly the most severe has been the great Japanese Deflation which commenced in 1990, leading to a banking crisis in 1997. This Japanese experience, whilst different in many ways to the work-out of the Great Depression, nonetheless has a similar asset bubble foundation and is proving just as enduring, continuing to this day.

GFC impact on US housing and bank activity

In each of the cases above, excess debt helped to create a major asset bubble, generally in property markets, which ultimately burst, undermining or rendering insolvent large portions of the banking sector of the country in question. The GFC has had a similarly dramatically negative impact on US residential property prices and the US banking sector over the past two years and is shown above.

Whilst then, the GFC is simply the latest such crisis to hit, it is perhaps the most dramatic financial and economic crisis of the post War period by virtue of its widespread impact on major developed economies, their property markets and, most importantly, their banking sectors.

Part B - Lessons From History

What lessons can be drawn from the recurrence of banking crises through history that may assist our understanding of the post GFC environment?

The most fundamental are that the impact and duration of the crisis on an economy and the financial sector is largely a function of three factors;

1. How severe the asset bubble was – the more severe the asset bubble potentially the more dramatic and enduring the impact of its collapse on the economy and financial sector.

1. How significantly affected is the banking sector by the asset bust - this is a function of how involved the banks were in funding the asset bubble through the provision of debt and their subsequent exposure to collapsing asset values. Property deflation tends to have a dramatic impact on banking sectors because of their traditional role as providers of mortgage debt financing.

1. How aggressive and ultimately successful the remedial actions by Governments are to stabilise and rebuild the banking sector post crisis - the more aggressive the remedial action the greater the potential for a recovery in economic activity and asset prices over a short time frame.

In general, the more over-inflated the asset bubble and, the more exposed the banking sector is to that bubble, the worse the ensuing crises and its impact on the affected economy and financial sector.

Using this rule of thumb, the GFC ranks highly on the scale of crisis. Being centred on the residential property market in major developed economies such as the US and UK, the bubble and subsequent bust has produced a tremendous negative wealth shock for an enormous number of people. This impact far exceeds the impact of the TMT crisis in 2000, which was largely a corporate debt problem for capital markets with relatively modest exposure on the part of banks and households. The impact of the GFC on the banking system of many countries has been disastrous with a number of banks failing or requiring emergency support to avoid collapse, in the aftermath.

It would therefore be reasonable to assume that the nature of the GFC ranks this event amongst the top tier of banking crisis going back to the Depressions of the 1890’s and 1930’s or the Japanese Deflation of the 1990’s, with the potential to be as severe and durable in its impact on economies. However, is there anything that gives us more comfort that the work-out of the global banking system, economy and financial markets post-GFC will be less severe and more rapid than history suggests?

US Bond Market pointing to risk of deflation post GFC

The importance of crisis response

Whilst the nature of the asset price collapse and the exposure of the banking sector to that collapse are important determinants of the nature of banking crises, the third factor listed above can have a major influence on the ultimate workout of an economy and its financial system following a banking crisis. That is, the nature and rapidity of response by political and monetary authorities to address and correct the problems in the financial and banking sectors, can have a major impact on the severity of the crisis and period required to return to normalcy. In this regard, the lessons of history are quite stark.

The magnitude and durability of the Great Depression and the Japanese Deflation can both be traced directly to abject policy failure at the time the crises began to unfold and in the years immediately following.

In the case of the Great Depression, following the onset of the crisis in the early 1930’s, the initialresponse by authorities globally was to leave interest rates virtually unchanged and to actually introduce fiscal austerity measures.