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View 01 Summer 2013

A magazine for Bank of Melbourne Private

Business culture See page 4

Economic power shift See page 8

Signs of hope for residential property See page 18

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Contents

Contents

8 Cover Story

16 Investment

22 Currency

Economic power shift

No room for complacency

Strategies to optimise your SMSF

4 Profile / Business culture 6 Profile / Down to earth 11 Investment Sentiment / Tempered buoyancy 14 Economy / Caton’s Corner 18 Property / Signs of hope for residential property 20 Q&A / The search for yield

Phone: 03 9274 4785 Web: bankofmelbourne.com.au/private View – A magazine for Bank of Melbourne Private Bank of Melbourne Level 8, 530 Collins Street Melbourne VIC 3000

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Note

Welcome Welcome to the first edition of View for 2013 Jonathan Ayres Head of Bank of Melbourne Private In this first issue of View for 2013 we’re sharing with you some of the results from the latest Bank of Melbourne Private’s Investor Sentiment Indicator, which reveals optimism among HNW investors after a volatile year. The latest survey shows a jump in positive sentiment, with the index now at its highest level in the six quarters of its history. While the optimism is still on the side of caution, many HNW investors believe the financial position of their households will be somewhat better over the next 12 months. On the residential property front, Bank of Melbourne Private economist, Janu Chan, sees the housing market as wellpositioned for moderate growth, with demand increasing as a result of limited supply. Investors are also buoyed by lower interest rates and higher yields as rents continue to rise across the country, and there is scope for further rate cuts. While house prices are trending lower than previous years, Janu expects to see modest increases of between 5/10 per cent per annum. Despite this optimistic view of the housing market, BT Financial Group Chief Economist, Chris Caton, reviews the Australian economy and explains ‘There is a myriad of things we can be doing better’. Emerging offshore economies are another sector attracting attention. In particular, India, which is one of Australia’s fastest growing economic partnerships. As the two countries continue to build an increasingly powerful relationship, business and investment opportunities are likely to expand over the coming decades.

New partnerships We’re pleased to announce that Bank of Melbourne has become an Icon Partner and the official bank of the Melbourne Cricket Ground. The partnership is based on our shared values and marks the first time in more than 100 years that the MCG has changed its banking relationship. Bank of Melbourne will also be a presenting partner in this year’s Melbourne Food and Wine Festival and we’d like to hear about your favourite culinary experiences in the city. Visit www.bankofmelbourne.com.au/mfwf to register your tips and you’ll go into the running to win dinner for two, every month for a year! If you have any questions about the articles in this issue of View, please speak to your Bank of Melbourne Private Banker who will be pleased to answer any questions you may have. Happy reading,

Jonathan Ayres Head of Bank of Melbourne Private

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Managers note Profile

Business culture Art, like commerce trade and politics, generates conversation. By Helen Vines Jason Yeap is proficient and successful in his chosen fields of endeavour but if he wants to really engage with people from diverse cultures, he talks about art. In this conversational space, “the dialogue is essentially about beauty”, he says. It is about history and culture; art provides a gentle segue from matters of money and power to questions of identity and values. As people from different backgrounds come together within the context of art, whether as investors, collectors, benefactors, or as artists or audience, there are opportunities, says Yeap, to bridge cultural divides and promote mutual understanding. A collector of Australian art (he has examples of work by Arthur Streeton, Hans Heysen, Brett Whitely, among others), Yeap was nominated to the Board of the National Gallery of Victoria in 2005. Although his tenure is drawing to a close, his interests have expanded. He now collects and hangs works of art from China, India, Vietnam and his country of birth, Malaysia; indeed any country he wishes to engage with and understand. As Chair of Supporters of Asian Art at the National Gallery of Victoria, he played an important role in the establishment of the Asian Art Acquisition Fund in February 2008. This fund adds to the significant holdings of Asian art at the gallery, with a particular focus on contemporary artists.

“the dialogue is essentially about beauty.” Yeap has a Bachelor of Science and a law degree and business interests across the globe; his “accidental” association with the National Gallery of Victoria opened up an “interesting way to understand one another”. And with the so-called ‘Asian century’ upon us, Yeap says he “cannot emphasise how important this is for Australia in the 21st Century”.

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It is the aspiration of all new migrants, particularly those from Asia, he says, to be seen to be contributing to Australia, and to be recognised as someone who has made the most of opportunities and has sought to reinvest in the community. That said, he has moments when he feels that Australians are yet to fully engage in a dialogue about their own identity. “We need to ask ourselves the question: ‘What does Australia mean to all of us?’” His perception is that, historically, Australia has been “incredibly successful in integrating a diverse range of cultures” although he has concerns that this has altered in recent times. This sense of ‘self’ influences how Australia locates itself within the Asia Pacific Region. These are important issues for all Australians, suggests Yeap. “Art and culture provide a good path for this conversation”, he says, drawing a parallel with our fascination with diverse cuisines. With new insights come new ways of thinking, and Jason Yeap, science graduate, lawyer, entrepreneur, art collector, proposes this is a good thing for us all. Helen Vines is a freelance writer.


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Profile

Down to earth Joost Bakker uses the ‘greenhouse effect’ to make things work, with unexpected benefits all round. By Helen Vines Joost Bakker is the artist and eco-advocate behind the Greenhouse projects. A knack for constructing working spaces that are sculptural and ecologically sound has launched his business onto the world stage. By tapping into a concept that an increasing number of people feel passionate about – sustainability – Bakker’s ideas and their practical applications are a hot commodity. A mission to recycle waste has driven his creative sculptures and artistic installations; now it also drives his core businesses in hospitality and construction. This happy marriage of philosophy and practice – at an affordable price – has found a receptive audience and clientele in Australia and overseas. Bakker and his business partners have restaurants, cafes and housing projects on the go. It was in 2008, in Melbourne’s Federation Square, that one of Bakker’s structures, composed of steel, straw and magnesium oxide board gained the appellation ‘the Greenhouse’. It has since entered his corporate lexicon, evolving from a one-off ephemeral installation to an umbrella term that encapsulates a philosophy of “connectedness”; the practical application of that philosophy; and the installations or constructions themselves. Initially the installations were intended to demonstrate an alternative way of approaching construction. “My intention wasn’t to create a business, but to purely do an installation that showed examples of ideas I had,” says Bakker. He had previously constructed a unique top floor installation in the Eureka Tower; built a house that featured in Vogue Living, and in 2006 designed a corporate marquee for the Melbourne Cup where clients could, quite literally, cool their heels. As Bakker recalls, the marquee was so insulated it felt like standing under a tree. Bakker overtly lays claim to be first and foremost an artist. He says he looks on the Greenhouse as “a completely creative building or artwork” and an experimental exercise. “I do lots of stuff that other people probably wouldn’t do because they are scared of the risks. But for me, that’s what the building is about”. In his business plan for his entry into

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the hospitality industry, most recently with Silo, a Melbourne city café in Hardware Lane, the detail is important: “every single thing has a story and everything is done for a reason”.

Right now he’s busy developing restaurant projects: in Melbourne, Sydney and London, “There is a lot going on,” he says.

Bakker doesn’t patent ideas, he engages in dialogue with anyone who wants to talk about issues of sustainability and their resolution. “Friendly advice,” he calls it. In his view there is “no point trying to keep things and spend money on protecting ideas. You’re better off moving quicker and just evolving and getting onto the next idea”.

The Greenhouse is built using recycled and recyclable materials. Every detail is meticulously planned to ensure the building lives up to its name. Bakker isn’t afraid of raising eyebrows with his experimental ideas. He and his business partners deliver on sustainable practices in all aspects of design, delivery and construction. The integrity of the supply chain is sacrosanct.

The bottom line is he even recycles ideas. More persuasive than didactic, Bakker leads by example. As an artist he “comes up with creative ways to show ideas,” and says the Greenhouse is his best example.

The apprenticeship Bakker’s interest in art began early. As a boy he travelled from his home in Rustenburg, north of Amsterdam, to draw with the Dutch artist Jan Hollenberg. In 1982, at the age of nine, his family migrated to Melbourne and established a business growing flowers. Leaving school at 17, he eventually found a niche as a florist specialising in highly creative floral and plant arrangements. The enterprise embraced a diversity of aspects including lighting – pendant “nests” built from fencing wire – and an export business. Bakker’s growing renown attracted a gallery owner, which led to his first solo exhibition in 2002. Not a single piece sold. Undeterred, Bakker launched into furniture and object design. He was invited in 2006 to showcase his work in an installation on the top of the Eureka Tower in Melbourne. The work involved suspended plants and discarded tree trunks wrapped in plastic encased in glass and steel. The effect, he says, “was eerie and haunting – a beautiful experience of nature combined with architecture”. With Joost’s Greenhouses visiting in Sydney and permanently in Perth, Bakker is excited about a world where diverse cultures can be neighbours by virtue of technology and swiftness of travel. He describes himself as very practical: “I come up with ideas that some people say are crazy, but they’re all doable. My dreams are about using less and I almost always work with waste that people are discarding, or I try and get rid of waste. That’s my goal.” Bakker’s hospitality business emerged from a desire to provide a practical purpose for his first Greenhouse installation of 2008 at Federation Square. A rooftop garden grew vegetables to feed the diners. Since then, Bakker has delivered increasingly sustainable dining experiences for his customers. “I try and make the chefs and diners realise that the choices they make when they cook and eat the food has a real impact on how it is grown, and the viability of the farm.”

No-waste supply chain Bakker counters the erroneous notion that organic practices or increasing sustainability are more expensive than current models. “This is incorrect,” he says, pointing to the dairy industry as a good example. For his cafes, milk is sourced directly from the farmer and delivered in 20-litre stainless steel vats that are returned empty and reused. Non-reusable packaging is banned. The best part, says Bakker, is that the dairy farmers can look at downsizing rather than being locked into an expansionist model. “Instead of getting 26 cents a litre from a processor, they can get $1.20 by supplying cafes direct, which is what we pay for our milk,” he says. “I’ve spoken to farmers and said ‘why don’t you reduce your herd, you’re pushing your animals to the limit, reduce the herd rather than constantly needing to expand, do the opposite’”. That philosophy extends to Bakker’s relationships with vintners and mineral water suppliers who deliver products using returnable kegs not bottles. These are simple and logical solutions, he says, to problems of waste, regardless of whether it is money, objects, labour or energy. For Bakker it’s just a contemporary extension of practices prevalent half a century ago. Back then, the notion that you would create something like packaging that would just be discarded was unthinkable. “It is a very recent idea that we’re creating so much waste,” says Bakker. “But people can, and do change. The best way to have an idea accepted is to demonstrate a 25 per cent saving. People don’t necessarily care if it is an environmentally friendly source or not; they are making a commercial decision.” It’s simply a happy by-product that these investment decisions result in less toxicity and waste in the environment we live in. Even Bakker’s own children report that school projects are addressing issues of waste and recycling, with a favourite being a competition for the least amount of lunch packaging. It makes him very optimistic about the future of the planet. View

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International

Economic power shift As the Asian century unfolds , India is grabbing the attention of investors. By Tracey Evans

Prime Minister Julia Gillard’s visit in 2012 to India has underlined the potential value of the country to the Australian economy as emerging market economies, particularly those in Asia, begin to pull their economic weight. More than a third of the world’s economic output is now located within 10,000 kilometres of Australia and it’s expected to continue to rise, according to Federal Treasury Secretary Dr Martin Parkinson in a recent speech. “Clearly, much of this shift is attributable to the growth of China and India – combined, these economies accounted for less than one-tenth of the global economy twenty years ago. Today they account for over one-fifth.” Long-term projections, as far ahead as 2050, place India as one of the biggest economic powers in the world. It wasn’t always the case. Despite having the world’s second largest population after China, India was struggling before the introduction of tough economic reforms during the 1990s. They helped India to withstand the global financial crisis and set the country on a path to prosperity, according to many commentators, notwithstanding a slight weakening of late. For Australia, it means that business and investment opportunities in India are likely to expand over the coming decades as the two countries build an increasingly powerful relationship, says international economics and diplomacy expert Professor Peter Drysdale, a member of the Advisory Committee that guided the work of the taskforce for the Federal Government’s White Paper on Australia in the Asian century. Drysdale, the Head of the East Asian Bureau of Economic Research and East Asia Forum at the Australian National University’s Crawford School of Public Policy, notes that China’s population is expected to peak relatively soon and the labour force has already begun to shrink. “So relatively what’s commonly called the ‘demographic dividend’ [a rising economic growth rate due to an increasing number of working age people] is running out of steam. Whereas in India, the demographic structure is still quite young and the demographic dividend will continue for quite some time.” (see graph) 8

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In the next five years alone, the expectation is that there will be about 12 million young entrants to the Indian workforce, says Drysdale. “On top of that, there are 3 million Indians under the poverty line that can be drawn into more productive activities. So the opportunities to capture the benefits of the expansion of the workforce opportunities are strong,” he says. “India now has a high investment rate from domestic savings, with about 40 per cent of GDP going into investment and 36 per cent of that drawn from domestic savings. With that level of investment, given the relationship between investment and output, India has a potential rate of growth of at least 10 per cent a year. That means that growth rate can absorb population growth and deliver strong growth.” Australia’s trade relationship with India has grown rapidly; in fact it’s one of our fastest-growing economic partnerships. “India accounts for about 4 per cent of our total trade. We export around $19-$20 billion worth of goods and services to India, mostly coal, gold and education,” says Drysdale. “We should also welcome and encourage greater investment from India, to help open up the commercial links between the two countries. “The expectation is that, if India continues to open up, Australia’s opportunities there will parallel the growth in trade with East Asia,” Drysdale says. % 75 China 70 India 65 Australia

60

55 50 2010

2015

2020

2025

2030

2035

Source: UN population projects and Australian Treasury, 2011

2040

2045

2050


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Managers note Investment Sentiment

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Snippets

Tempered buoyancy Wealthy Australians are becoming more and more optimistic, according to the Bank of Melbourne Private Investor Sentiment Indicator. The latest survey of high net worth (HNW) investors shows a jump in positive sentiment, with the index now at its highest level in the six quarters of its history. The overall score in the Bank of Melbourne Private Investor Sentiment Indicator in the first quarter of 2013 was 13.4, compared with 5.4 for the previous quarter. “There’s still a sense of cautious optimism,” says Jonathan Ayres, Head of Bank of Melbourne Private, “but in the lead-up to Christmas there were several factors, international and domestic, that slightly tempered the green shoots of investor enthusiasm. Perceptions of slowing growth domestically, lingering doubts about the European debt crisis and the ‘fiscal cliff’ stand-off in the United States undoubtedly pulled investor buoyancy back again towards the end of last year. “As well as the uncertainty overseas, there was a stalemate in federal parliament, which dampened a lot of business owners, professionals and entrepreneurs who run or drive their personal earnings through their businesses. That non-productive final session in parliament meant they didn’t see a lot of strong commitment from the government to do something substantial around growth or make large infrastructure calls.” Jonathan Ayres sums up the HNW investors’ optimism following a year of volatility as modest, cautious and wellinformed about the trade-off between risk and return. “We are certainly starting to see them be more positive about taking on some extra risk if they are being rewarded for that extra risk. For example, they are looking for pockets of opportunity in commercial property, particularly types of specialist property, and looking beyond our borders at distressed assets overseas. HNW investors have a global view and they are also taking advantage of our currency strength.” View

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Investment Sentiment

“There’s still a sense of cautious optimism.” The Investment Sentiment Indicator, produced by Bank of Melbourne Private in partnership with CoreData Research Australia, provides an insight into investment markets by examining both past results and investor intentions. It comprises five key drivers: market prediction, household financial security, investment satisfaction, new investment product purchase intention, and intention to invest new money into existing investments. For the most recent survey, more than 220 HNW investors were interviewed in the February 13-27 period from CoreData’s panel of about 17,000 Australians holding investment portfolios of $1 million or more (not including their superannuation or principal place of residence). Those with an annual household income of $250,000 or more are also classified as HNW investors. The indicator also compares HNW investor sentiment with that of ‘mass affluents’ – investors holding smaller portfolios of $50,000 to $750,000. The research shows that sentiment among mass affluents typically lags HNW investors by about 12 weeks. While sentiment for this group remained in negative territory, it improved to -4.2, it’s highest level since 2010, compared with -7.0 in the previous quarter (Q4 2012); -9.9 in the third quarter and -23.5 in the second quarter (the lowest level recorded in the indicator’s eight-year history).

Investor intentions Despite the renewed optimism, HNW investors indicated they were less likely to make further investments, compared with the last. The Investor Intention Indicator registered a drop from -6.4 in the period before Christmas to -12.0 in the first months of 2013. As with the Investor Sentiment Indicator, there is a considerable difference in intent among the mass affluents, who are still much less likely to invest (-19.6) than HNW. “The difference may be partly explained by the HNW investors having more active investment strategies based on broader sources of advice, and generally being more willing to rebalance their portfolios in a timely fashion,” says Jonathan. In terms of asset class, the 2013 first quarter data reveals that HNW investors continue to consider equities as the most preferred class when rebalancing their portfolios. The HNW equities sentiment index has jumped to 32.0 points, its highest level in six quarters. The Mass Affluent investor equities sentiment has also increased to 11.0. This is the first time it has been positive since Q2 2011.

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In contrast, two in five say they are less likely to invest in property trusts, the bond market or cash. More than 68 per cent of HNW investors believe the Australian share market will outperform residential property in the next quarter. This has grown from 41.2 per cent in Q4 2012. Similarly, the proportion of Mass Affluent investors that believe shares will outperform property has increased this quarter, although not to the same extent as HNW investors. The shift in sentiment suggests the equities rally is expected to continue. Looking at the broader picture, many HNW investors anticipate an improvement in business conditions in the next quarter. Meanwhile there’s been a considerable increase in the number of HNW investors who believe the financial position of their households will be somewhat better over the next 12 months. The proportion of HNW investors who expected the Australian economy to grow at a faster rate over the next quarter increased from 22 to 35.8 per cent. Accordingly, those who thought it would slow down fell to 40.1 percent from 52.8 per cent in the previous quarter. Ayres says the HNW sentiment indicator has a strong correlation with the ASX 200. “We’re cautious about saying it’s a predictor, but, if you overlay the general markets behaviour on the ASX 200 chart, you’ll find a big lag in people’s behaviour compared to the indicator. The correlation is tighter when it comes to the HNW investors’ sentiment because they’re far more nimble and in tune with the sentiment of the actual market. “The old rule of thumb is that the soft market is telling us what may or may not happen in nine to 12 months’ time, so that tells us that the HNW investor is looking that far out as well. They’re not just reacting to today,” says Jonathan. The long-term value of the indicator is reflected in the fact that, the predictions of wealthy Australians over the past eight years of the sentiment survey has been extremely accurate, and those who followed these predictions would have been better off than those who kept invested in the ASX index..


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Economy note Managers

Caton’s Corner February 2013 Share markets began 2013 in fine fettle. For the month of January, the US market, as measured by the S&P 500 index, advanced by 5%, to its highest monthly close since October 2007. In the past year, the S&P500 has risen by 13.1%. The US market is now up by 121.4% from its early-March 2009 trough. Over the past 50 years, when the January result has been positive, the year has turned out to be positive 83% of the time. The ASX 200 index rose by 4.9% in the month, to its highest monthly close since August 2008. If one were looking for a reason for this continued strong performance, one could perhaps say that “nothing bad happened”. In the US, the earnings season began and so far it has been positive. As a general rule, more companies report earnings above expectations than below, in part because they “manage” expectations beforehand. This year, this “upside surprise” phenomenon has been more pronounced than usual. In the US, there was one nasty piece of news: GDP (the nation’s output) actually fell in Q4 2012, something that happens very rarely outside of recessions. There were special factors, however, including hurricane Sandy. The best news in the US in January was that the worst outcome was avoided in its fiscal mess. Early in the month, the “fiscal cliff” was avoided as Republicans and Democrats agreed on a medium-term deficit reduction package. In addition, the next instalment of the debt ceiling issue, which roiled markets in August 2011, was postponed for several months. It is tempting to think these problems have gone away completely. There are, however, still some rocks ahead. Sequestration is currently due to begin on 1 March, and the current continuing budget resolution expires on 19 March. A further one must be passed by 27 March to enable the government to continue to run. Failing passage of a new resolution, there would be a shutdown. Shutdowns used not to be particularly unusual. There were fifteen between 1977 and 1995, lasting between 1 and 17 days. Since the Clinton/ Gingrich shutdowns in 1996 (26 days in total), there have been none. Congress is likely to move fairly swiftly on a new resolution; if this is not done by mid-April, the members of Congress won’t get paid! Debt limit issues need to be addressed by 19 May.

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Chris Caton Chief Economist BT Financial Group The other two international “flashpoints”, China and Europe, were remarkably quiet in the month. Long-term rates in Europe continue to decline, which is a good sign.

And in Australia The two most important pieces of economic news in the month were the employment report and the CPI release. Both, in a sense, gave the RBA carte blanche to cut further should it so desire. Estimated employment fell by 5,500 in December, and shows a mediocre 1.3% growth in the past year. Meanwhile, the unemployment rate rose from 5.3% to 5.4%. Inflation remains low; in the year to the December quarter, the headline CPI increased by just 2.2%. Despite the soft labour market and benign inflation news, the RBA Board will probably elect to “leave well enough alone” at its meeting in early February. The previous reductions in rates are still working their way through the system, and the RBA is probably less worried about the immediate risks to the Australian economy coming from abroad, and also about the effects of weaker commodity prices. The Bank would still be concerned about the ongoing high Australian dollar, but there’s not much it can do about it. During January, much was made of the fact that the banks’ cost of funding has been reduced in recent months because of a decline in their wholesale costs. What this probably means is that any further cut in the cash rate will be matched point for point by declines in variable mortgage rates.

The Coming Election Late in the month, the Prime Minister, Julia Gillard, delivered a major surprise in announcing that the next Federal election would be held on 14 September. We have never before known the date so far in advance. This led to immediate speculation that the current Government is now a “lame duck”. In fact, the Government will not go to “caretaker” mode until the election writs are issued in August.


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I won’t be deciding my vote on economic-policy grounds, but the economic policies of the two protagonists will be a focus of the campaign. It is worthwhile pointing out that the Australian economy is in much better shape than the rest of the developed world. Unemployment and inflation are both low, we have no public debt problem (despite what the shock jocks tell you), and we have had no house price crash. We avoided most of the effects of the GFC. The Government should have been able to take more credit for this performance than it has been able to do. Despite the relatively good showing, business and consumer confidence remain low. There appears to be two main reasons for this. One, the two-speededness of the economy means that many industries and regions are languishing, particularly those hurt by the high Australian dollar. Two, the fact that we have a minority government means that there is no policy certainty. Whichever way it goes, the election should at least end this state of affairs. There will be much focus on responsible Budget policy in the campaign. I have said in the past that a rapid return to surplus is not good economic policy; in fact it would be bad for the economy. It will be interesting to see how much we hear about repeal of the carbon tax. This has rapidly become “part of the furniture” (as did the GST). It’s difficult to identify many harmful effects, in part because both low-income consumers and many industries were over-compensated. That said, the Gold Coast City Council remains firmly opposed to the tax. My suspicion is this issue may quietly go away, although Mr Abbott’s recent rhetoric suggests otherwise.

Glenn Stevens had it right when he said “get the list” from the Productivity Commission, and do the things on the list. There is a myriad of things we can be doing better (reduction in red tape, better transportation policy etc). Productivity can also be enhanced by “slow burners”: things that will eventually make a lot of difference but will take some time to have an effect. Education and infrastructure (which may necessitate greater use of public debt!!) are two that stand out.

Where are we going? Last month, I published an end-2013 forecast for the ASX 200 of 5100 points. I pointed out that this was much stronger than the mean forecast (4557) of a panel of equity analysts polled by the AFR. A month into the year, and already my top-of-the-market forecast is looking low. I will wait for a few months before adjusting it. Chris Caton BT Chief Economist The views expressed herein are those of the author and should not be otherwise attributed.

The two sides may both make noises about protection of manufacturing, and particularly of the car industry. The mercantilist viewpoint won’t go away. There is still a popular belief that “it’s not economic output if you can’t drop it on your foot”. The fact is, however, that for decades economic growth throughout the developed world has primarily taken place in the service sector. In the past 20 years, the number of jobs in Australia has increased by more than 4 million (more than 50%) with no contribution at all from manufacturing. There is no point in shoring up an inefficient industry in perpetuity; the costs to Australian consumers of doing so far outweigh the gains to producers and workers. A case can, of course, be made for short-term protection, e.g. because an industry is in temporary difficulties because of the high level of the currency. Perhaps the biggest economic issue facing Australia is productivity growth. I have written of this in the past. In recent years, much of our poor productivity performance has been camouflaged by real income gains coming from our rising terms of trade. That luxury is unlikely to be available to us in the immediate future. What can we do?

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Managers note Investment

No room for complacency Australia has just entered one of the most difficult periods of recent history, but good results can be achieved. By George Toubia

An increasing number of growth decelerating factors are confronting the Australian economy including the high Australian dollar, declining terms of trade, significant fiscal tightening and a maturing profit cycle in the mining sector. Growth in emerging economies is also likely to slow while other developed markets will remain firmly in a low to no growth environment. Monetary policy levers will be ineffective at reversing the global growth slowdown, debt de-leveraging and deficit management. But a liquidity injection orchestrated by the central banks of developed countries is likely to reduce excessive downside risks in the marketplace. In Australia, it is imperative that declining productivity and the strength of the currency are addressed. For example, Switzerland is targeting its currency by enforcing a ceiling on the exchange rate to protect what’s left of its competitiveness. The US Federal Reserve does it indirectly by flooding its system with cash and Brazil does it by regularly altering tax on inward investments. The need for debt management is also just as important in Australia as elsewhere; the only difference is that it is about personal balance sheets in Australia (as opposed to public balance sheets in the US and Europe). We are extremely relieved that the Reserve Bank is finally recognising the softness of the mining sector and the weakness in other domestic sectors. It’s an opportunity to be ahead of the curve by jump starting confidence and activity. And yet, state governments are showing a lack of corporate mindset as they continue with royalty policies that have limited regard to the increasingly challenged profitability of the mining giants’ operations in Australia. It’s time to enrich, not weaken, those long-term corporate relationships. Meanwhile, the possibility of interest rates being lower than where current market expectations deem them to bottom 16

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George Toubia BT Private Wealth Chief Investment Director

(2.50 per cent to 2.75 per cent for official rates and 3 per cent for long-end government yields) should not be ignored. A budget surplus is simply unachievable and the deficit will gradually rise. The yield curve is very flat and that is a credible signal for far more moderate growth in the next two years than current expectations. In this environment, the search for quality becomes even more critical. Quality comes in various forms: for credit investors, it is unquestionable debt serviceability and a shorter term outlook; for equity investors, it is earnings resilience (as opposed to growth); for real estate investors, it is value retention and tenant quality.

Embracing foreign investment Investing offshore is increasingly a necessity rather than a choice. Given the Australian market’s weighting towards financials and mining, investors focusing on domestic equities are facing fewer opportunities to access global franchise equity return streams – and specifically those that offer global earnings resilience and limited base metal commodity exposure. To that end, investing in global equities has its merits. It is true that less than 25 per cent of global equities are showing leadership but there is an opportunity for those with seasoned stock picking skills. In Europe, not only are sovereign funding costs subsiding, those of European banks are too. The primary market for banks has just re-opened (with about 21 billion euros of senior unsecured paper) and – following the inability to access US dollar funding over the last two years – French banks have just been able to do so.


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As a clear signal of the market’s willingness to lend when reform is embraced and progress is made, Ireland has successfully issued medium-term debt recently. In addition, the European Central Bank reforms have had the desired effect of crushing the risk premium in Italian and Spanish sovereign debt, as seen in lower short-dated yields. Meanwhile, the move by the US Federal Reserve to prioritise employment over inflation is questionable. We are not convinced that these actions will deliver the desired goals. If employment is the objective, then corporate management’s confidence is the Achilles’ heel. That will not be restored through keeping rates low – both US mortgage rates and borrowing costs are already low.

IMPLIED VOLATILITY

US EQUITIES

GERMAN EQUITIES

AUSTRALIAN EQUITIES

1 month

12%

16%

10%

3 months

15%

20%

11%

6 months

18%

21%

13%

12 months

20%

23%

15%

3 years

23%

24%

17%

5 years

25%

26%

19%

10 years

28%

27%

21% Source: Bloomberg. Various Banks

Volatility advantages

Gold continues to shine

The unlimited nature of central bank liquidity injection is now having a strong impact on investor mentality by removing tail risk pricing from the market.

Twelve months ago, investors considered the world was awash with liquidity. Today it has more liquidity than it had a year ago and in a year’s time it will have more than today.

Across currency, credit and equity markets, short-dated price volatility is seeing significant compression. This is now resulting in lower implied volatility and a steep term structure of the volatility curve between spot and 18 months. Similarly, the equity volatility term structure (the equivalent of an interest rate yield curve but in volatility terms) is steep between spot and beyond 12 months. While it can be argued that this is too steep, it highlights that – for the short term – market participants believe that the central bank liquidity can be an effective band aid. For those investors that are interested in positioning themselves in asset classes with limited downside risk, low implied volatility (up to 12 months) affords a cheaper option than at any time during the last few years, making riskreward payoffs more attractive.

Relative value As public credit opportunities get full in valuation, yield-based ideas in other markets will invariably present good relative value. In equity markets, these opportunities can be exploited if downside risk is tightly managed. Suitable methods include enhanced buy write strategies and strategies with conditional capital protection. We expect Australia’s equity market underperformance compared with global markets to persist, owing to another domestic cycle, this time away from mining and defensive yield stocks (such as utilities and telecom) towards interest rate-sensitive sectors (such as banks and diversified financials) and event-driven equity investing.

The open-ended and unlimited liquidity injection by the US Federal Reserve, the European Central Bank, Bank of Japan and Bank of England will pump at least another 1.5 trillion US dollars into the financial system over the next 12 months. As central bank balances have expanded, the gold price has climbed. The combination of low US/EU short-term interest rates for at least another three years and a perceived fear of resurging inflation from system liquidity (which in our opinion is unfounded) also serve to support the case for gold.

From a basic supply and demand standpoint: •• Strikes in South Africa at large producers (AngloGold and Goldfields) are causing production stoppages.

•• Indian demand for gold eased this year due to the high gold price in Indian rupee terms (as the rupee sharply depreciated) and the lower farming income due to monsoons.

•• Chinese demand is positive but lower than previous years as Chinese inflation has eased to 2 per cent from 5 per cent last year.

•• Importantly, central bank gold buying continues at a healthy pace particularly by Turkey, Russia, Philippines and Mexico. The loss of faith in paper currency, in the face of abundant currency supply, makes the case even stronger for gold’s wealth preservation power.

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Managers note Property

Signs of hope for residential property The residential property market, in some parts of the country, is one small bright spot in a less than glowing outlook for the Australian economy. By Janu Chan With mining investment set to peak, there is hope for other areas of the economy to fill the gap. Unfortunately, some of these sectors have been slow to pick up. The economy is expected to grow at a touch less than 3 per cent in 2013. While this is slightly below long-term trends, it is a reasonable figure in comparison to many other advanced economies. Housing is one area of the Australian economy that is wellpositioned for moderate growth. There is pent up demand because new supply has been limited. Unlike some other countries, Australia has yet to see a large run-up in residential construction. At the same time, population growth has picked up once again, after slowing throughout 2010 and 2011. Successive interest rate cuts since November 2011 have also begun to have an effect on the market although not all parts of the country are feeling the benefit. In the year to December 2012, prices were slightly down overall, but 1.5 per cent higher in Sydney and 0.8 per cent

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higher in Perth. Darwin led the way with price increases of 8.9 per cent in the year to the end of December, according to RP Data-Rismark.

Slow but steady improvement The conditions are right for growth in house prices, and an improvement in residential construction. In fact, conditions in the residential property market have been improving for the past year. For owner-occupiers, affordability has increased. Over the past 12 months, there has been a pickup in first home buyers as a proportion of owner occupiers in most states. New South Wales has been a notable exception, where there have been changes to the benefits for first home buyers purchasing established homes. Generally, first home buyer activity is important for driving a recovery in housing, because it adds to housing demand and provides a market for those wanting to upsize.


Snippets

For investors, rental yields are higher than in previous years. Rents have continued to rise across the country, led by Perth, Darwin and then Sydney.

people’s desire to either enter the housing market or upgrade. Concerns about job security are likely already, keeping potential home buyers sidelined.

The improved yield is encouraging to many investors, who are now also appreciating the low-interest rate environment. Low vacancy rates indicate there is still strong demand for rentals, and there is scope for rents to rise further. Rental markets are considered tight in Sydney, Melbourne and Canberra (vacancy rates under 3 per cent) and very tight in Darwin, Perth and Brisbane (vacancy rates under 2 per cent). The recent stabilisation in house prices should also give greater confidence for investors to purchase.

A reluctance by Australian households to increase their levels of gearing, following a trend in recent years to pay down debt and increase savings, may also restrain prices. Household debt as a proportion of disposable income remains high although it has declined from its peak in 2007.

Over the next year, we should see some modest house price increases of between 5 per cent and 10 per cent per annum. This is a much softer pace of growth than in earlier years. It is unlikely we’ll see the nearly 20 per cent growth that was witnessed in the early 2000s any time soon. But we expect a recovery nonetheless. Cities that are primed for price increases include Perth and Sydney, which have both struggled to lift residential construction rates.

Subdued conditions in Melbourne Melbourne may continue to underperform until the recent boost in supply flows through the market. Conditions have been subdued in Melbourne, with property prices falling 2.5 per cent in the 12 months to the end of November, following a large run-up in price over 2009-10 and a high level of construction in the Victorian capital. In the longer term, Melbourne is well-positioned for growth. It has twice been ranked the most liveable city in the world by the Economist Intelligence Unit. It is also a leading city for education, and both factors will generate population growth, which will be supportive for housing. Victoria’s population is growing at an annual pace of 1.5 per cent; ahead of NSW at 1 per cent and in line with the national average.

Dollar still a concern The major area of concern for the outlook for housing and the domestic economy is the high Australian dollar, which is weighing on certain sectors such as manufacturing, tourism and education. With commodity prices having fallen and interest rates also now lower, it has been somewhat surprising that the Australian dollar has stayed so strong. The high currency’s impact has been varied, and has had more of a tightening effect on certain areas of the economy than others. There also remains concerns for the global economy. The debt problems in Europe are complex and have the potential to destabilise financial markets. Although leaders have taken important steps to resolve some of the issues, the region is in recession and unlikely to see much growth next year.

Despite the risks, there are reasons to be optimistic. Talk of the mining boom coming to an end has been overdone. We are heading into a new production phase that promises to increase Australia’s export capacity. Economic growth in China is stabilising, providing a solid base for continued demand, and although the peak in commodity prices is probably behind us, the situation is not as negative as some commentators would suggest. In the US, notwithstanding some fiscal challenges, the outlook for the largest economy in the world is also generally more positive, given its housing sector is finally on the mend.

In Tasmania, conditions are likely to continue to lag for some time as the high Australian currency and rising unemployment impact housing markets in that state.

The range of data to date also suggests that a recovery in housing has still further to run, although the signs are somewhat tentative. Housing finance is growing at a modest pace. Auction clearance rates are picking up slowly. An encouraging sign is the improvement in home buyer sentiment, according to the most recent Westpac-Melbourne Institute “good time to buy a dwelling” index which is at its highest since September 2009.

There are some uncertainties that could dampen a recovery in house prices. While the unemployment rate is currently low, there is a risk that it could edge higher. In many parts of Australia, business conditions are subdued and companies have indicated they are somewhat concerned about the outlook, which may weigh on hiring, in turn impacting

If the outlook turns out worse than anticipated, there is scope for the Reserve Bank to stimulate the Australian economy by cutting rates further. This would help mitigate any fallout from a deterioration in economic conditions. The more interest-rate-sensitive areas, including housing, would therefore be set to benefit.

Brisbane and Adelaide have not performed as well as other Australian capital cities. However, that doesn’t mean we won’t see improvement in those cities in the longer-term.

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Q&A

The search for yield What’s the outlook for fixed interest investments? BT Private Wealth’s Chief George Toubia talks to BT Investment Management Head of Income and Fixed Interest Vimal Gor.

Vimal Gor Head of Income and Fixed Interest BT Investment Management

George Toubia: Given the contraction in both credit spreads and significant rally in government yields, where do you see the opportunities and risks in fixed income investing as at now?

them and they tend not to come back to the market. But, if we compare that to what’s happening in Europe, the US and UK, where markets are experiencing large amounts of quantitative easing, liquidity is also drying up.

Vimal Gor: On a long-term valuation basis, Australian bonds are overvalued. But, when we’re going through a deleveraging and a slow-growth environment in the global economy, we know that these deleveraging cycles take a while. We think it is unlikely that bond yields will rise in the medium term and there is significant risk that bond yields will fall further to provide capital gains from that part of your portfolio. Irrespective of whether you think bonds are over or undervalued, the key is to have bonds as part of a balanced portfolio because they offer diversification against equities. If you don’t have bonds and just have term deposits, you don’t get any negative correlation benefits. GT: The government bond market of Australia is significantly held by overseas institutional investors. Isn’t that affecting the price action in that sector and its liquidity? VG: The latest numbers show that around 80 per cent of Australian bonds are held by overseas investors. If you look at the RBA [Reserve Bank of Australia] breakdown, Australians only own about 5 per cent of the Australian bond market. When you see large holdings from overseas, they tend to buy the bonds and lock them away to get the yield out of

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GT: There’s probably a positive angle in that sovereign or global institution players, holding Australian government bonds for the longer term, gives certainty that this will remain a relatively stable market as opposed to one that may experience forced liquidation? VG: That’s the point. If there’s large overseas buying it’s because it’s a quality asset. We have a very good credit rating, very low net debt to GDP ratios – there are myriad strong reasons why you should be buying Australian bonds, and that is what has driven the overseas holdings up to such a high level. We think it’s a good thing. Australian bond yields are one of our favourite assets in the world and we still favour being long here. GT: Obviously we’re surprised that market participants are not allowing for the possibility for lower yields in Australia, especially with the structural change our economy has to go through. What are your thoughts on that? VG: Yes, that’s a key point for bond yields – a lot of people didn’t believe they’d go this low; we’ve hit new all-time lows this year and we forecast they will fall further. Part of the reason people are so concerned about the level of yields right now is they can’t get their head around the RBA taking real interest rates negative, so they believe the floor on interest rates will be somewhere around 2 to 2.5 per cent.


We don’t believe that’s the case. The RBA will be more than happy to take rates negative if the economy pans out as we’re seeing it. We see a problem in 2013/14 when the mining capital expenditure will slow without a boost from the rest of the economy to offset it. We were saying back in early 2011, when rates were at 4.75 per cent, that we thought they’d bottom out between 1 and 1.5 per cent sometime in 2014 and we stand by that forecast. GT: As for other opportunities within your mandate – such as the semi-government bond market, swap spreads and currency opportunities – what areas represent reasonable value outside government bonds for you? VG: We have a strong view that swap spreads globally should continue to tighten as they have done throughout the world. Obviously Australian swap spreads have come in recently, but the narrowing is much more pronounced in the overseas markets and that’s because governments are explicitly trying to bring down that credit premium. If you look at the UK’s Funding for Lending scheme, the government is actually lending to small business via banks, therefore there should be zero swap spread in the market. While we understand why Australia structurally should trade with a higher swap spread than globally, we still believe there’s more room for swap spreads to fall and we are playing that trade. In terms of currencies, we believe the US dollar is undervalued in the medium term and that the Australian dollar is very overvalued. GT: Would you reconsider Australian government bond risk if the Australian dollar falls, given the large number of offshore holders of Australian government debt? VG: We’re not worried about wholesale selling of Australian bonds, but it is something that we look at and try and model. It’s fair to say that the large scale reallocations into the Australian dollar have already happened. While overseas buyers normally buy bonds unhedged, and therefore a weaker currency will negatively impact their holdings, we think they’re reasonably happy with their exposures right now.

central banks globally are driving asset prices up to levels that may not be sustainable over the medium to long term. The clearest example of that is the US equity market. The period we’ve had recently is very similar to what we saw earlier in the year when the market movement upwards was all based on multiple expansion. GT: As a veteran fixed income and interest rate portfolio manager, what observations do you have in terms of how the world responds to a very low interest rate environment and flat yield curve? VG: That’s an interesting point about the yield curve because Australia has by far the flattest yield curve of any developed market. Numerous empirical and academic studies show that the steeper the yield curve, the more likely the growth; the flatter the yield curve, the more likely growth will slow. That’s a potential worry for us, and one of the reasons we expect growth to tail off over the next couple of years. When comparing Australian investors relative to the UK and US, in Australia we’ve been very lucky to have high yield and it would be fair to say that’s going to stop. Interest rates are going to continue to come down and we need to get used to generating a lower level of return on our assets. If you look at the level of holdings in fixed income in Australia relative to overseas, we are materially lower. There are a couple of reasons for that including our demographics. But it’s not hard to see Australia moving to the same equity bond weightings they have in the rest of the world. And that will mean material will shift into fixed income, and the acceptance of lower returns that goes with that. GT: Even if decisions are made to reallocate to a world standard in terms of equity bond balances, doesn’t the size of these domestic markets make it technically difficult? VG: Yes. In an environment where bond yields will probably stay at current levels or go slightly down over the next few years and the US equity markets will probably trade in this range, you need active management of both your equities and bonds. That’s why you need to look at managed funds and have your manager actively move your asset allocation around for you.

GT: You analyse forward-looking indicators and commodity inputs in terms of the effect on risk appetite and the general level of spreads. Are there any strong signals right now from your process? VG: What’s jumping is that many asset classes – specifically US equities – are being driven by liquidity, as the search for yield goes on. You can see that clearly through credit spreads, which are deteriorating. So it’s very clear to us that

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Business

Strategies to optimise your SMSF The rules for self managed superannuation funds allow for many different strategies. Here are three to get you started. 1. Property development without borrowing

allows members to potentially make two contributions in

If you’ve ever wondered whether you could use your SMSF

June, claim a tax deduction for both, and then allocate the

to develop property, the good news is it can be relatively

second contribution to the member in the next financial year.

straightforward if the SMSF owns the land and is able to fund

This strategy can provide a ‘double tax deduction’ but there’s

the costs of the development with existing cash. However,

a catch: the contribution must be allocated to the member’s

it’s important to note that while SMSFs may borrow, within

account within 28 days of the end of the month in which the

certain rules, to buy land, borrowed funds cannot be used to

fund received it.

cover the costs of developing property. You also cannot use

For example, if an SMSF member wishes to contribute say,

cash to develop land that you have borrowed to buy, until

$50,000 (two contributions of $25,000 each) to their fund in

the loan is paid off.

June, the full amount may be claimed as a tax deduction but,

One way an SMSF can complete a property development on

given the annual concessional contribution cap of $25,000,

land it owns but doesn’t have the funds to develop is through

the member would have created an excess contribution of

a development agreement.

$25,000. If the fund puts the second $25,000 contribution

Under a development agreement, the SMSF joins with another party who agrees to pay the development costs. The SMSF must retain ownership of the land and the

into the SMSF’s contribution reserve it can be allocated to the member in the following financial year and tested against next year’s cap.

developer may only be compensated from the profits

Another type of reserve account is the ‘anti-detriment’

[of the eventual sale].

reserve – a pool of funds used to pay out additional death

The development agreement is a legally binding contract made on a commercial basis. Development costs must be recorded at market value and the land cannot be encumbered by the agreement. There are also rules that apply if the developer is a ‘related party’ of the SMSF. Related

benefits to an eligible spouse and/or dependants when members of the fund die. These payments are increases in lump sums paid on death to eligible dependants and effectively represent a refund of the tax on contributions paid by the deceased member.

parties include members of the SMSF, their relatives or any

The anti-detriment payment increases the death benefit

companies they control as well as, in some cases, employers

to beneficiaries and increases tax deductions for the SMSF

that contribute to the fund.

which may offset any current capital gains from having to

2. Reserving benefits for the future

selldown assets, other assessable income and future capital gains and tax on contributions.

Some SMSF trust deeds specify the use of ‘reserve accounts’ which can help manage peaks and troughs in

3. Using lump sums to fund income

income, as well as maximise tax deductions and benefits.

If you’re retired and aged between 55 and 59, it’s possible to take lump sums from your SMSF at any time and it can be tax effective for some. This rule applies whether or not you’re taking a pension.

A ‘contributions reserve’ is one of many different types of reserve accounts. It holds contributions to the fund before they are allocated to a specific member’s account. This 22

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“With the right advice, you may be able to successfully unlock a vast range of investment and strategy options.” If you are in pension phase and aged 55 to 59, using lump sum payments to meet your minimum pension requirements, rather than income payments, may be useful because lump sums are taxed differently. As an individual, the first $175,000 of taxable component drawn as a lump sum is tax-free and anything above that is taxed at 15 per cent (plus Medicare). So if your minimum income requirement is, say, $110,000 per annum as a couple (ie $55,000 each) for the three years to age 60 you could meet your minimum income obligations without paying any taxes. This strategy depends on your circumstances and the amount of taxable and non-taxable components in your individual fund. This is because you have to withdraw

tax-free and taxable components together in their relative proportions and you cannot just take taxable component by itself. With the right advice, you may be able to successfully unlock a vast range of investment and strategy options for your self managed superannuation fund. The strategies mentioned here provide general information, so you’ll need to check whether they work for your fund. It’s also worth remembering recent changes to the regulations, requiring that SMSFs give consideration to holding life insurance cover for members. Your Bank of Melbourne Private Client Adviser, drawing on a range of expert resources, can help to ensure you comply with the often complex SMSF rules.

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Disclaimer: This publication has been compiled by Bank of Melbourne. Bank of Melbourne Private provides specialised services to customers of Bank of Melbourne. Bank of Melbourne – A Division of Westpac Banking Corporation ABN 33 007 457 141 AFSL and ACL 233714. The information and any advice in this publication is general in nature and does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness having regard to these factors before acting on it. It is important that your personal circumstances are taken into account before making any financial decision and as such, you should seek detailed and specific advice from a suitably qualified adviser before acting on any information or advice in this publication. The information contained herein does not constitute an offer to acquire a financial product. Your individual situation may differ and you should seek independent professional tax advice in relation to your circumstances. Material contained in this publication is an overview or summary only and it should not be considered a comprehensive statement on any matter nor relied upon as such. Any taxation position described in this publication is general and incidental to the financial advice. You should consult a registered tax agent for specific tax advice on your circumstances. While the information contained in this publication is based on information obtained from sources believed to be reliable, it has not been independently verified. To the maximum extent permitted by law: (a) no guarantee, representation or warranty is given that any information or advice in this publication is complete, accurate, up-to-date or fit for any purpose; and (b) neither Bank of Melbourne nor any member of the Westpac group of companies are in any way liable to you (including for negligence) in respect of any reliance upon such information or advice. Any outlooks given in this publication may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. Past performance is not a reliable indicator of future performance. This document has been prepared for use only by advisers and clients of Bank of Melbourne Private. While the information contained in this document has been prepared with all reasonable care no responsibility or liability is accepted for any errors or omissions or misstatement however caused. All forecasts and estimates are based on certain assumptions which may change. If those assumptions change, our forecasts and estimates may also change.  BOM20321 01/13

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