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Corporate Strategy Weekly Radar Update

Week ending Friday 14 December 2012 (After the 'Fiscal', the US 'Monetary' Cliff)
Financial Services IAG finally sold its UK operations in 2 separate transactions: Equity Red Star (specialist motor underwriting) for ~A$130M to a Private Equity, and its commercial broking operations (currently undisclosed) to a consortium led by current management. IAG expects to incur a net loss after tax of ~A$240M on the disposal, higher than expected due to the retention of pension liabilities. o Most issues came from deep structural problems caused by the UK recession: surge in payouts linked to car accidents driven by claim farming (lawyers acting on a no win, no fee basis, leading to more litigation and inflated payouts); rise in fraud which happens in during economic downturns; while intense discounting over recent years also resulted in Equity Red Star failing to price for risk. o Before todays sale, IAG UK was valued at about $350M including goodwill: it ended it being sold at <10% of its $1.4B purchase price 6 years ago. However analysts assert that the higher than expected loss will be outweighed by investors' relief. HSBC will pay a record US$1.9B to settle a US probe for illegally laundering money for Mexican drug cartels and violating sanctions with countries including Iran, Cuba, Libya, Sudan and Myanmar. o It comes after Standard Chartered paid $674m to US regulators for dealing with Iran, and RBS and UBS are bracing for a wave of fines for attempting to rig the LIBOR after Barclays 290m penalty in June. The key angle is that a fine was preferred to criminal prosecution, because the later would have likely resulted in a revocation of HSBC's licence given the violations of anti-money laundering, anti-terrorist legislation and sanctions imposed on regimes regarded as rogue state by the US. Prosecutors estimated that this would have threatened the stability of the financial system. This raises questions and sets a precedent on financial institutions that are "too big to indict": a regulatory predicament. It also questions whether these fines, whilst record in size, are true deterrents given their relatively small % of market capitalisation and profit of these institutions(<6% PBT): setting a pattern by which penalties could be written off as part of the cost of doing business. (notwithstanding the reputational damage, both HSBC and StanChart enjoyed investors confidence and share price rallies). QBE announced details of their capital raising- $US500M convertible debt securities to mature in December 2039 with a floating interest rate of +3.25% above 6mth US$ LIBOR rate. The raising will comply with Tier 2 APRA regulatory capital (which had been questioned). o The raising was flagged during last month's profit downgrade after Sandy. Some analysts questioned why QBE have opted for a lower grade of capital and have concluded equity raising may be required in the medium term because its capital remains "tight" against another natural disaster, which could trigger future dividend cuts. Meanwhile, a number of hedge funds recently took sizeable borrow on QBE with the expectation of raising in the next month or so with the intention of short-selling the shares and covering the short position at the discounted raising price. IAG joined with other major organisations (incl Westpac, Optus, Munich Re, Australian Red Cross) to commission a white paper calling for further natural disaster mitigation. It will be written by Deloitte Access Economics by 1H13. o SUN has made similar calls for increased government action on disaster mitigation. Govts spend on average only $27M/year on disaster mitigation (e.g. flood levies, bushfire breaks) whereas insurance companies paid out over $6B in claims in 2011. Banks expect to grow their share of personal retirement savings by 25% over the next 15 years through low-cost super. Retail Super funds owned by Banks and Wealth companies like AMP should go from 11.2% today to 14% in 2027 share of the personal Super. o 'Suncorp Everyday Super' (0.85% investment fee + $6.5 admin fee/month), 'ANZ Smart Choice' (0.5% annual investment management fee +admin fee of $50) are anticipating next year's no-frill MySuper. Losers are expected to be corporate schemes and self-managed funds (which have grown fast recently due to easing regulation regarding.. Financial Services (ctd) o ... borrowing against SMSF to buy residential property, and lack of confidence in the share market). Westpac will spend $240m refurbishing 1/3 of their branches lounge style with the intent to move from manual transactions towards financial advice. This will occur over the next 3 years and reduce average branch size from 400m2 to 200-250m2. o A trend (eg NAB did this 3-4 years ago). It is driven by: savings in real estate leasing, the consequence of pushing customers towards online self-service and therefore moving branch staff from "counting coins and cheque deposits" towards higher value advice and sales. Westpac plans to increase automated transactions from 15% to 30%, with branch staff to become specialists in SME, Wealth and Relationship Management. Other Industries GPT bid for Australand's $2.94B commercial property: rejected bcse too low (GPTs offer is $140m higher than book value): this could signal a wave of M&A in the listed real estate sector. Macro Economy, Politics and Regulation The US Fed launched Quantitative Easing 4 (QE4): $US85B a month from $US40B by printing money and using it to buy bonds. Effectively this means that the developed world is engaged in a "currency war" with global ripple effects: o The AUD reacted to QE4 by rising to US$1.06 this week. o The AUD exchange rate is also held higher by foreign central banks diversifying their portfolios and buying it: Russia and Germany are thought to be key buyers. o Which adds to other international QE policies (in UK, Japan) o From an internationally point of view, emerging economies such as China, Brazil, as well as commodity exporters such as Australia are negatively impacted, with QE not boosting demand for their exports, pushing the major currencies down and theirs up, making them less competitive. o Domestically, the RBA is still reluctant to take more interventionist approaches in managing the A$ down. Following last weeks disappointing Aust economic figures (falls in residential approvals, wages, company profits, and while real GDP has grown at a trend rate ~3.1%, nominal GDP upon which budget forecasts are based, slowed considerably to 1.9%) Treasury suggests low commodity prices will keep budget in deficit for 2 more years, and calls for Govt to abandon surplus o The Business Council of Australia added "they would forgive the govt if it failed to achieve long-anticipated surplus, provided it had a well articulated medium-term strategy" calling for building reserves, limiting govt spending to 23.7% of GDP, also calling the coalition to commit to a set of rules. Adding to those views, conflicting business confidence indices were released by NAB (fall) and Roy Morgan (improvement). o The fall reflects the structural change of the Australian economy but the contradiction also illustrates that policy makers (esp. the RBA) will want more data before deciding any move. Nick Greiner, ex-NSW Premier, surmised GST reform would return to the fore in the 2H13 (post-Federal Election). Along with ex-VIC Premier Brumby and businessman Bruce Carter he recently released a review of how GST is allocated to the states. o Renewed calls for a reform of the tax system following inaction after the Henry review: Business, states and even the Australian Council of Social Services are calling for the GST to be included. On the US front, the stalemate on the Fiscal Cliff continues: Republicans maintain calls for Obama to nominate spending cuts, whilst Democrats seeks tax rises on the wealthiest 2%. The shape of the EU banking supervisor is becoming clearer, with finance ministers approving measures on how it should look, and guaranteeing key concessions to London preventing the EU to "steamroll regulation on the City".

By now, we've all heard about the US Fiscal Cliff. But did you know about the Monetary Cliff? And what it means for us. We knew about the US Fiscal Cliff.. (a quick recap) Spillovers from the US fiscal cliff: IMF simulated output losses (2013) If lawmakers do nothing, the US face fiscal tightening in 2013 worth up to 5% of GDP: a Greek-scale squeeze. It would not take many months to push the country into recession. A complete stand-off between Obama and Congress would lead to disaster even sooner, for unless lawmakers vote to increase the debt ceiling (the maximum amount of debt that the Treasury can issue) by around March, the federal govt will be unable to pay its billsincluding, potentially, its bondholders. The damage from a self-induced default would actually dwarf even that from the fiscal cliff. The IMF also simulated the global spillover (in the appropriately named '2012 spillover report'): neighbours would be most affected. But China and several advanced countries would also suffer up to 25% of the hit taken by US growth: Lower commodity prices (6%-12% for energy and 3%6% for non-energy, depending on confidence effects and policy responses) would also adversely affect net exporters (incl. Australia)

But there is also a Monetary Cliff... The US Fed pushes policy to far frontiers On one hand, the Fed faces demands to take more action to boost the lagging economy. Growth is sinking towards 1% as Obama and Congress debate the aforementioned Fiscal Cliff, and unemployment remains unacceptably high more than 3 years after the official end of the GFC. On the other hand, there are critics who worry that the Feds extraordinary bond-buying policies its $US2.8T balance sheet could hit $US4T by early 2014 are doing little to boost demand while storing up problems for the future. So markets have been wondering since 2008 how the Fed will get out of this unconventional injection of liquidity (Quantitative Easing). The question is whether there is a risk that the Fed will act to hastily to run US corporate profits as % of GDP after the yield curve (mostly to anticipate inflation). There is a precedent: in 1994 Greenspan had maintained rates too law (3%) too long before lifting short term rates to 6% within months, causing a blood bath on the Bond markets. 10yr rates shot from 5.5% to 8%, causing significant losses of capital (according to the bonds-rule-ofthumb: 'rates and prices work in opposite') So to prepare the market, the FED is now taking the historic step to explicitly set targets on inflation and unemployment: Sceptics, particularly among congressional Democrats, have in the past worried that an explicit inflation target would relegate the full employment goal to the back burner. But Bernanke was careful to stress that setting an inflation target did not mean the central bank would lose sight of the other side of its dual mandate: "We are not absolutists, If there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment, then that is something that we would be willing to do.": The FED wants to bring unemployment to 6.5% and clearly said so. The trouble and what underpins this Monetary Cliff is how more injection of liquidity (QE) will manage to cut the unemployment rate: o US companies have been experiencing record profits and margins, o Their balance sheets are strapped with cash, All Sources:, US Fed, AFR, Goldman Sachs, IMF o Household debt remains at record high... o ... and 10 year bonds have already been below 2% for 18 months: so how will a marginal decrease of this already low rate trigger a surge of business investments to generate growth? Will already indebted households borrow even more to consume? ..these are questions puzzling observers. In fact the Fed hopes the economy gets healthier soon, and that Washington fixes the fiscal political fight. Then it can push interest rates and its balance sheet back to a normal range without a crisis. But if these things don't happen, the US could be headed over a Monetary Cliff: hyperinflation or a brutal hike in interest rates, which will make the present Fiscal Cliff look tame in comparison. The impact on Australia is very material: QE bond buying programs in the US (but also EU, UK, Japan) have artificially suppressed the value of the $ Capital flows out of the US, EU and Japan (pushing their currencies lower), and into higher-growth countries such as Australia (pushing their exchange rates higher). At the same time, the AUD is pushed higher as foreign central banks try to protect themselves from currency wars by adding high-grade assets, such as Aust bonds, to their portfolios. The RBA hasnt ruled out intervention, but economists believe it's reluctant to intervene to drive the AUD lower because it believes, until now, that a freely floating currency has acted as a stabiliser for the economy. The RBA could do like Switzerland which capped the Swiss franc at 1.20 to the euro. However it seems the Swiss could do that because their interest rates are close to zero, so it costs it virtually nothing to issue Swiss francs in exchange for foreign currencies that have at least a marginal positive return. In contrast, economists argue the RBA would incur a running loss, because the Australian cash rate is 3%, and any foreign assets that the RBA bought would generate lower returns. In addition, it is believed the RBA risks running up considerable capital losses if it intervenes. The Swiss National Bank has accumulated foreign assets equivalent to 70% of Swiss GDP. If the RBA intervened on the same scale, that would mean it would have to sell $1 trillion worth of AUD which would incur capital losses (which taxpayers would ultimately have to pay for) if this strategy failed to prevent an appreciation of the dollar.