Corporate Strategy Weekly Radar Update

Selected highlights from Jan - early Feb 2013 (snapshot: 2013 outlook) Financial Services The NSW and TAS bushfires earlier this year as well as Tropical Cyclone Oswald were a reminder of the continued importance of disaster mitigation to put reduce claims costs and insurance premium: major insurance bodies and providers are urging govts to invest more. o SUN advocates for disaster mitigation since the 2011 Qld floods. According to Suncorp's Risky Business report, Australia's exposure has dramatically increased due to more frequent extreme weather events, economic growth, urbanisation and population shifts towards high-risk areas. Relatively modest investments in flood or fire mitigation could significantly reduce the cost of disasters when they occur. o The Insurance Council of Australia (ICA) also commented that reinsurers globally have increased Australia's risk profile because of large losses and the failure of govts to increase mitigation: the federal govt contributes $27m a year to be compared with $13B total cost of the 2010-11 'Summer of Disasters' in QLD o Insurers are beginning to estimate losses from the current bushfires across south-eastern Australia. According to the ICA, losses in Tasmania are expected to rise well above current estimates of $42M with more than 410 claims lodged to date. 4 year delay of the full implementation of the Basel III liquidity reforms for banks, incl. a broader range of assets that will satisfy requirements: Full implementation postponed until 2019 (60% of the required liquidity buffer will be required by the original 2015 deadline, phasing up to 100% by 2019). In addition to highly-rated government bonds and cash, banks will be able to include mortgage-back securities, corporate debt and shares (max. 15%). o Impact on Australian banks will depend on APRA, which could still impose more stringent requirements than international standards as it did last year for the separate Basel III capital reforms: APRA's position will be known mid-year. New rules are estimated to give $70B back to Australian banks, which should flow into loans. o The move follows heavy lobbying by US and European banks who argued for putting growth head of prudential tightening the global economy continues to struggle. The US Justice Department filed a $US5B lawsuit against Standard and Poors and parent company McGraw-Hill, claiming the ratings agency knowingly understated the credit risks of instruments, including residential backed mortgage securities (RBMS) and collateralised debt obligations (CDOs), in the lead up to the GFC. o Agencies have faced criticism for granting top grades to securities that packaged sub-prime home loans, a key catalyst for the GFC. Last year the Aust Federal Court found S&P and ABN Amro liable for advice they gave to councils that invested in complex financial instruments. o The lawsuit coincides with investors being invited to join the class action against CBA over losses from synthetic collateralised debt obligations (CDOs), claiming significant non-disclosure of the risks involved. It also follows NABs agreement to pay $115M to settle a class action against shareholders also relating to losses on CDOs. The continued independence of mortgage broker Aussie Home Loans is questioned following CBA's takeover (80% stake, with the right to acquire the remaining 20% in 2016). Aussie currently sells loans from 18 different lenders. o This coincides with Macquarie Group taking an 8.3% stake in financial services group Yellow Brick Road (YBR) in Dec12, and follows a mortgage origination partnership whereby Macquarie uses its balance sheet to supply credit for YBR borrowers. The deals are ironic given both Aussie and YBRs initial positioning as alternatives to the major banks; and raises questions about the sustainability of non-bank lenders in the current post GFC funding environment. Whilst not breaking news, Westpac chairman Lindsay Maxsted confirmed the Bank is the target of regular cyber-attacks which absorb a substantial part of the IT security budget. This echoes ASIO director-general David Irvine that local companies are not doing enough to prevent cyber-attacks. Financial Services(continued) They are subject to 1.2 successful attacks a week, according to HP research that found cyber crime was costing Australian businesses an average of $3.2M a year, with some hit with as much as $10M in costs annually. o A strategic risk also picked up by the World Economic Forum under the label "Digital Wildfires in a Hyperconnected World" The govt is set to reform the corporate bond market with draft legislation this week (following a 3-year consultation): it will exclude companies from publishing complex prospectuses and reduce rules around directors' liability. o The aim is to reduce bureaucracy in this $49B market, to encourage businesses to enter the fixed-income market, and to encourage the $1.46 trillion superannuation industry to buy more corporate debt (therefore tap into that savings pool) and to domestically fund investment and in turn reduce reliance on offshore wholesale funding markets. Other Industries Australia Post is accelerating its transformation "to future proof the organisation against rapid internet-driven changes" with the recruitment with the Head of Microsoft Asia Pacific (a theme developed by Ziggy in his future of work publication - link to his video presentation). Tracey Fellows will lead the new communications management services, combining the previously separate postal services and e-services divisions. o The Post is investing $2B to revamp its logistics (parcels) and has become the second-most valuable brand in the country behind Apple. Last year, the former loss-making business generated an after-tax profit of $281.2M (+17%) for a revenue of $5.1B. It paid the govt a dividend of $213.7M. Macro Economy, Politics and Regulation
The RBA kept cash rates on hold at 3%, citing improved global confidence (avoidance of US fiscal cliff, stabilising growth in China): decision largely in line with economists expectations and echoing the global sentiment that 2013 should be a year of "more sunny breaks and fewer storms" - see appendix o The decision was supported by the release of positive economic data including a 1.6% rise in average capital city house prices in Dec12; a reduction in the trade deficit to $427M (the narrowest in 10 months) due to an increase in iron ore exports; and the unemployment rate remaining steady at 5.4%, despite predictions for an increase. o However conditions remain tough in the retail sector, with a 0.2% fall in retail sales for December (a 0.3% rise was expected), suggesting consumer sentiment remains cautious. However the revenue from the Minerals Resource Rent Tax (MRRT) falling short of forecasts with $126M collected in the first 6 months of the 2013FY, against expectations of $2b in payment this Financial Year reminds us that systemic issues remain, even at home (namely the outstanding need for Tax reform) o The figures reaffirm the pressure on federal government revenues and highlight the impacts from volatile commodity prices, a high currency and global uncertainty. Forecasts for FY13 were recently downgraded from $3b as part of the Mid-Year Economic and Fiscal Outlook (MYEFO). China released reform guidelines, including the loosening of interest rate restrictions imposed on banks, as part of the countrys wealth distribution plan. o Chinas deposit rates are currently kept artificially low, providing cheap capital and driving profitability for Chinas state-owned banks. Interest rate liberalisation could help foreign banks operating in China to compete against the cheaper sources of funding from Chinese lenders.

A snapshot of the global outlook for 2013 At the very macroeconomic level.. we are on a collision course with the 'Debt Supercycle'
Public Debt in Advanced Economies - 2011 $US GDP-weighted average Financial markets are on a collision course with the Debt Supercycle (a term

Public and Private Debt in the US as % of GDP

coined by Montreal-based BCA Research, describing a persistent increase in national debt relative to GDP) which started in the 1970s Public debt in advanced countries has climbed from 30% of GDP to more than 100%. (incl. US, EU, Japan) Total (private and public) debt in the US has more than doubled to 380% of GDP over the same period. A similar trend has unfolded in other developed countries. Historically, debt grew in line with GDP, rising faster during booms and falling back during busts. The IMF notes that things have changed since the 1970s: central banks interventions in those advance economies has moderated downturns and kept the corrective phase of the debt cycle "from fully playing out." As a result, recoveries have launched from successively higher plateaus of debt. During expansions, central bankers have been slow to withdraw stimulus, accentuating the build-up in borrowing. With the debt burden becoming ever more onerous, recoveries take longer and longer to get going. More alarming is how relentless the upward spiral has become: Even after the financial crisis of 2008, there are few signs of reversal. We are now in a 'reflationary' period, when the economy is being pumped up by central bankers and other policy-makers.

Looking at various geographies: Three Big Issues And The Potential For Positive Surprises 2012 was characterised by nervousness and volatility, "frustrating There seems to be a consensus emerging about 2013 that the global for almost everyone": economy should pick-up in the second half of 2013: "more sunny breaks and o Those who were violently bearish on growth were 'disappointed' fewer storms" - however this is mostly looking for some positive surprises in because the global economy did not fall back into recession and the coming year - not the resolution of all the systemic issues. equities moved erratically higher Three major areas have been weighing on sentiment among consumers, o Those who were if not bullish at least optimistic did not see the businesses and investors: the euro crisis, Chinas economic outlook and US resolution of the major structural problems to validate their views. fiscal dysfunction. The Euro Crisis: Narrowing The Euro Areas Competitiveness And Balance Of Payments Gaps The Euro Crisis: A complex mess, involving interrelated elements of a banking crisis, a debt crisis, a balance of payments crisis and a growth crisis. With no single fiscal authority and with 17 countries with different agendas and economic situations, policy has moved incrementally, responding only when disaster was imminent. o However the ECB has been forced to step in the bank crisis and announced unlimited financing to the EU banks. o The sovereign debt aspect of the crisis is not yet resolved but, major fiscal adjustment has already occurred in the periphery with the drastic Austerity (at a massive social cost) but all the periphery countries, bar Ireland, are expected to be in structural primary surplus in 2013. (a drop in bond yield spreads confirms that the sovereign debt crisis has calmed) o The 3rd crisis, divergence in competitiveness between core and periphery, reflected in differences in current account performance: the drastic austerity measures have translated in macro-shifts as much of the periphery is closing the unit labor cost gap with Germany. o The final element of the crisis - need for growth has yet to be resolved. It is an effect of Austerity which might have improved the indicators cited above but has been a recipe for disaster for growth and high unemployment rates causing social disorder. The outlook for China Some slowdown in growth was inevitable in response to policy tightening in 2010-11 and the resulting cooling in housing activity. A key risk is a "middle income trap" which occurs as growth slows and eventually plateaus after reaching middle income level. The problem is to avoid being 'stuck in the middle': On one hand rising wages make developing nations less competitive than low-wage economies in low-skill cheap manufacturing. On the other hand, they are unable to compete with advanced economies in high-skill innovations. As China has hit the World Bank's definition of middle income (GDP is greater than US$ 4,000/capita), there is realization that it is entering a new phase of development. Growth slowdown coincides with the point where it is no longer possible to boost productivity by shifting additional workers from agriculture to industry. The Chinese leadership is well aware of those dynamics and will invest in technology so that it doesn't continue to lag far behind developed countries in innovation and productivity, and try to reduce income inequality so economic growth is more spread.

The outlook for China

US Fiscal Dysfunction The 'fiscal cliff' issue was arbitrarily imposed and resolved by congress, and does not deal with the real problem: the need for reform of the US tax system (higher than OECD average but low on Goods and Services: tax revenues as % of GDP need to rise but by closing loopholes, which could even allow marginal rates to go down, and ultimately a "US GST" will probably be needed. Interestingly the IMF has estimated the fiscal adjustments that various countries need in order to bring debt-to-GDP ratios back to 60% by 2030 and found that the US needs far more adjustment than the peripheral Euro area currently punished by markets, and only Japan is in a worse position.

Australia should remain one of the strongest developed economies, but have we done enough for the rainy days? In the shorter term, in 2013, trends previously enunciated at our November board session will keep unfolding. The macroeconomic fundamentals of the past years remain related to our international situation: o In the same way Canada is tied closely to the US, Australia's fortunes are closely linked with that of China. o Consensus among international analysts is that overall it should remain one of the strongest developed economies. o Contrary to countries that are trying to figure out how to grow again, Australia's challenge is whether the current prosperity has caused a relative delusion on how to best harness it and prepare for the rainy days (which we will only know when those days come - the below chart shows that if history repeats itself, we are due for a commodity cycle downturn; and the chart of the left show that we have one of the highest consumer debt in the world which might bite us hard if the macroeconomics become weaker.) 'Domestic' items that will be influenced by 2013 being a Federal election year include: o Activism, likely to increase in this Federal Election year as illustrated by the Whitehaven hoax. o Now that the Federal govt has abandoned its commitment to surplus, it will be interesting if it will create more political room for 'stimulus and handouts' to voters in the election year... o If APRA follows the regulatory 'reprieve' from Basel III, it should play in favour of the banking sector. o Question on whether consumer sentiment will respond to further RBA cuts. o The continued pressure of Technology on various sectors and the pressure on Technology companies to 'mature' into the mainstream real economy: serendipitously illustrated by Twitter about to open an office in Australia to help combat cyber bullying and deepen ties with the federal and state governments. (ie. they cannot afford to remain a 'virtual' company anymore). The US Is No Longer The King Of Consumer Debt, dethroned by Canada and Australia A Long-Run Perspective Of Commodity Cycles

Sources: The Bank Credit Analyst - January 2013 - Vol. 64 - No. 7 " special year end issue: outlook 2013 - Fewer Storms, More Sunny Breaks", The Economist, IMF