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AMP Capital Investors Limited ABN 59 001 777 591, AFSL 232497

Here we go again…

US political gridlock and its implications 3 OCTOBER 2013

Two separate but related US political issues have the potential to unsettle financial markets in the immediate period ahead. To date, global markets appear to be taking the current US political theatre in their stride given increasingly supportive global economic fundamentals.

US Government shuts down non-essential services The first and most immediate issue for markets is the US Government shutdown of non-essential services that has now taken effect. The US Congress has missed its 30 September deadline to pass legislation that authorises the provision of funding for government programs during the new 2014 fiscal year (commencing 1 October, 2013). The US Senate (Democrat-controlled) has passed legislation authorising funding but the House of Representatives (Republican-controlled) has rejected it because they do not support President Obama's new healthcare bill, known as Obamacare. Republicans will only agree to approve a temporary spending bill in exchange for concessions on the healthcare bill, which they view as wasteful and oppressive 1 as it requires most Americans to have health insurance . It is estimated that up to 800,000 government workers could be laid-off until Congress approves US Government funding or at least reaches an interim compromise to buy more time. Meanwhile, services deemed ‘essential’ will continue, among them those related to national security, mail delivery, air traffic and law enforcement. A shutdown is not a new thing with the last occurring in midDecember 1995, under President Clinton. In fact, there have been 17 shutdowns between 1976 and 1996 although they were most common in the 1970s and 1980s. It is difficult to know how long the current deadlock will last. On its own a short-term temporary closure of government services has not historically been a major issue for financial markets (although it is certainly important for those employees immediately affected).

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However, a potentially larger issue is the risk of a more profound disagreement over the need to raise the US Government’s borrowing limit, the ‘debt ceiling’.

The US Government is quickly approaching its debt ceiling The US Government’s limit on borrowing is currently set at US$16.7 trillion. As the government is running a budget deficit (currently around 4% of GDP) it needs to borrow to continue to fully fund its operations. The US Treasury – responsible for arranging these borrowings and debt repayments – has indicated that its ability to borrow may end on 17 October. A failure to agree a lift in the borrowing limit is potentially much more serious than the current shutdown as it would mean that the government would automatically be required to balance its budget. Unable to borrow any more money to fund its operations or refinance existing borrowings, it would need to draw from government revenue sources. The government would also run the risk of defaulting on its debt repayment obligations.

What has been the market reaction? As the US political process runs it tortuous course, investors will be interested in: > How long US Government services will be shut down; and > Whether the US Congress can reach an agreement to increase the Government's borrowing limit. For now, markets do not appear to be reacting adversely, but market sentiment can change quickly. If markets formed the view that a government shutdown could endure for longer than expected, there is a risk of a decline in investor confidence. This may reflect a fear that something unfortunate could occur which could unhinge US growth from its current recovery path and thereby affect US corporate earnings. US corporate earnings remain one of the key strengths of the US economy; providing a solid fundamental underpinning for the market’s impressive gains over the past year.

Victoria Craw and AAP, What happens if the US Government shuts down?,

News.com.au, October 1, 2013, 6:52PM

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Nonetheless, some signs of more cautious global investor sentiment have encouraged a decline in bond yields, particularly in the US market. As a result, we believe that there is the potential for increased short-term volatility in financial markets. The action taken by US politicians in relation to the duration of the government shutdown and the lifting of the debt ceiling will have implications for investor sentiment. It is important to note that in this case, markets may not react to the shutdown itself but to the debt ceiling negotiations.

Global outlook Despite US political gridlock, the fundamental global economic backdrop is improving:

lack of clear fiscal policy frameworks in the US could remain a source of ongoing medium-term concern.

Final thoughts It is unknown for how long the partial shutdown of the US Government will continue, but it goes without saying that the longer the shutdown remains in place, the larger the potential impacts on US growth. If it is over relatively quickly its impact on the US economy should be very limited and no more than a passing distraction. We believe that US politicians will agree to raise the US debt ceiling before the 17 October deadline. However, until that we expect equity markets to experience heightened bouts of short-term volatility.

> Stimulatory monetary policies remain supportive of equity investing; > Moderate US growth is continuing; > Europe finally appears to be recovering with growth returning, albeit slowly; > Japan is growing with the help of strong policy stimulus; and > China's economy looks to be in a stronger position than earlier this year.

Globally, monetary policy remains highly stimulatory and 2 this is likely to remain the case for the foreseeable future. Indeed, the US Federal Reserve has recently decided to continue with the purchase of financial assets to the tune of US$85 billion a month under its open-ended quantitative easing program and its effective zero interest rate strategy. This strategy has underpinned US equity gains with the Federal Reserve indicating that it plans to keep the strategy in place so long as it perceives risks to US recovery, such 3 as those resulting from the inaction of US policymakers.

What does this mean for investors? Equities are at risk of increased volatility in the month ahead as the US budget and debt ceiling negotiations continue. However, any downturn in equity markets is likely to be temporary in nature. Equity valuations remain reasonable, stimulatory monetary conditions are set to remain and as Australian growth picks up, profits are likely to follow suit. By 2013 year-end, the potential exists for upside in global and Australian equities with gains continuing into 2014. Perhaps one disappointing feature of the current US fiscal bottleneck is that the potential for further upward re-rating of share markets does depend on clarity in fiscal policy settings by politicians globally. Whilst monetary policy globally is doing its part to support more secure growth, the

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The Economist, Monetary policy after the crash, controlling interest, 21 September, 2013 3

Federal Reserve, Press release, 18 September, 2013

Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general informati on, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and 3 seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided.

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US political gridlock and its implications