MLC s views on Prospective 7 Year Real (after inflation) Return Potential (end March 2010)

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1 MLC s views on Prospective 7 Year Real (after inflation) Return Potential (end March 2010) Each quarter MLC Investment Management publishes an assessment of prospective real return potential for asset classes and MLC s diversified portfolios (the MLC Horizon Series and Long-Term Absolute Return Portfolio). We have now updated the analysis to reflect end March 2010 market valuations. This assessment is drawn from our proprietary Strategic Asset Allocation (SAA) scenarios framework, which is used to set and review the asset allocations of each of our diversified funds. 1. Using our Scenarios Framework to generate Prospective Return Potential 1 Our SAA scenarios framework considers over 40 different scenarios. Each scenario is a distinct economic and investment environment. Considering potential returns across many possible futures provides a comprehensive assessment of prospective risk and real return potential. This scenarios framework generates prospective returns for asset classes and diversified portfolios across each scenario. By weighting the scenarios according to our assessment of their probability, we generate a single expected real return for each asset class and portfolio. These expected returns are shown in the graphs by the blue columns. For comparison purposes we have provided long term neutral return expectations which are set by considering a stable fair value world (these are shown by the red boxes). Also, as an indicator of how uncertain these returns are, we have taken the bottom (& top) 10% of the scenario real returns and calculated the probability weighted average real return in those tail outcomes. Note that there are a number of different scenarios that could result in the kind of returns that constitute the top and bottom 10% (i.e. there is no single best case or worst case scenario). These are represented by the grey (& white) columns for each asset class and diversified portfolio. 2. Comments and Changes The investment environment continues to be difficult and fraught with uncertainty. In major advanced countries we have a stable but fragile disequilibrium based on historically low interest rates. There are a number of things that could upset this balance. Low rates are supporting the servicing of the growing debt overhang. A risk is that rising interest rates in the emerging world puts upward pressure on Western rates or requires currencies to devalue (subject to the pegged currency conundrum) - allowing in some imported inflation (the inflation risk is greatest in 1 Note that these calculations of potential return and risk reflect MLC s strategy and cannot be assumed to be indicative of potential outcomes for other strategies. The assessment of return potential is for listed assets only. We are aware of valuation inconsistencies between certain listed and unlisted assets, particularly property and infrastructure. In these cases unlisted assets are likely to have lower return potential and higher downside risk exposure. For private equity we expect very significant dispersion in returns with the vulnerability of lower quality exposures becoming clearer in this challenging environment

2 the UK). Both could upset the current scenario and interrupt the recovery. Policy mistakes represent another risk, particularly given short electoral cycles and the long politically unpopular period of austerity ahead. It has now been twelve months since the start of the dramatic rally in risk assets. Having anticipated considerable good news in 2009, markets have been more tentative in the first quarter of 2010, with risk alternately being put on and taken off. Outside Australia, Interest rates remain very low, supporting higher prices for risk assets. Australia s fortunes are irrevocably tied to China where policy is now walking a tightrope between over-heating and over-tightening, Mistakes in Chinese policy would undoubtedly have consequences for the Australian economy, currency and sharemarket. Tensions are growing between the United States and China over the reluctance to allow the Renminbi to appreciate. If not resolved, China s mercantilist policies may trigger a protectionist backlash. Importantly, the US economy is rebalancing away from over-consumption. Lower consumption means lower growth unless there is an offsetting positive. While growth this year may be close to potential this relies on hefty government support. The Euro zone and Japan are growth laggards. The European Union has announced a financial rescue mechanism for Greece this is unlikely to be sufficient. And whether it proves enough to provide financial markets with confidence in the sovereign debt of the peripheral European nations remains to be seen. What does this mean for markets going forward? In our scenarios assessment we continue to give the sustainability of the global economic recovery the benefit of the doubt in order to avoid underestimating return potential. While there is the potential for a muddle-through scenario with reasonable global growth, the medium term outlook for the advanced economies is fragile and doubtful. We are cognisant that while currently deflationary pressure is dominant, there are some emergent inflationary risks particularly in China and potentially in Australia too if the growth cycle remains robust and unemployment continues to decline. This is a complex, unusual and risky environment. Risk concerns continue to be the underlying driver of changes to the MLC Horizon portfolios under the medium term Strategic Overlay process: While government bonds performed admirably in 2008, increased issuance since the onset of the crisis has created its own risk. Global sovereign bonds have become less of a safe haven and we have recognised this via a change in the mandate for the global sovereign allocation to a cash benchmark. With the bulk of the gains now behind us, we are now reassessing the prospective reward for risk across the portfolios

3 In the near term we would not be surprised to see the Australian dollar move higher, but regard the currency as vulnerable to a return of risk aversion. We have increased our unhedged global equity exposure and expect to make further increases if there is significant further Australian dollar strength. 3. Overview of Analysis This analysis does not provide any information about short term performance. Near term market performance is extremely uncertain. Liquidity has been a key driver of market behaviour; what happens next depends as much on monetary policy as the real economy (and of course the two are inter-linked). The prospect of further short term equity market volatility remains as expectations about the strength of economic growth fluctuate. Key Points asset exposures: The return potential across all asset classes is largely unchanged after three months of relatively tentative price action. In aggregate, equity market return potential remains below long term normal levels. However over the medium term, despite the risks, equities may offer among the best potential to achieve the real return outcomes required by investors. If the world is lacking in pricing power, profits overall will be constrained but still there will still be some companies with pricing power. Alternatively, if inflation ultimately rises this would normally be associated with lower equity valuations, but in this case may not be if this is associated with an exit from a deflationary trap. We know also that some companies provide great inflation protection those with fixed costs (utilities) and fixed rate debt do best. Extracting the return potential for investors is about stock selection and manager selection rather than asset allocation. This is perhaps one of the least attractive times to adopt indexed equity strategies Capital preservation should have a relatively high priority in an environment dominated by near term deflationary forces, but there is no simple answer to which assets and strategies will provide a safe haven. Some traditional safe haven assets have lost appeal. Prospective debt asset returns generally remain below normal levels, particularly long dated global treasury bonds which have limited and below normal return potential and relatively high downside risk. That possibility, as well as the massive increases in Government bond issuance that are in prospect, pose significant threats to world bond markets. Inflation linked securities return potential is in line with long term normal expectations and, over a series of years, and the exposure is relatively low risk

4 Key Points MLC Horizon Series and MLC Long-Term Absolute Return Portfolio (LTAR): Prospective return potential appears below normal; short term outcomes are extremely uncertain. For MLC Horizon portfolios, risk-return efficiency and consistency of return with market outcomes is key. Risk control has been increased in the MLC Horizon portfolios we have focused in particular on changes to strategy which have an asymmetric pay-off, that is upside potential is limited relative to downside risk. For LTAR the key consideration is the reliability of long term real return outcomes, which requires that protection against the possibility of extremely adverse outcomes has greater importance than maximising upside participation. LTAR remains defensive relative to its Neutral allocation. Changes to the Neutral strategy were implemented in early 2010 which reduced risk exposure while maintaining return potential in line with objectives. Susan Gosling, MLC Investment Management - 4 -

5 20% 15% SAA Scenario Probability Weighted Real Returns (March 2010) (7 years, 0% tax with franking credits, pre fees, pre alpha) Probability Weighted Mean in 10% positive tail Mean in 10% negative tail Long term 'normal' return 10% Return % p.a. 5% 0% -5% -10% Equity Global equity Unhedged Global equity Hedged Emerging markets Wld Unhedged cash Short duration Diversified Debt All maturities Diversified Debt government corporate Global government Global corporate inflation linked Global high yield debt (extended credit) Insurance related debt - 5 -

6 SAA Scenario Probability Weighted Real Returns (March 2010) (7 year scenarios, 15% tax, after investment fees, with alpha) 20% 15% Probability Weighted Scenario Return Mean in 10% positive tail Mean in 10% negative tail Long Term 'Normal' Return 20% 15% 10% 10% Return % p.a. 5% 0% 5% 0% -5% -5% -10% MLC Horizon 1 MLC Horizon 2 MLC Horizon 3 MLC Horizon 4 MLC Horizon 5 MLC Horizon 6 MLC Horizon 7 LTAR Neutral LTAR Strategic Overlay -10% - 6 -

7 Important Information: Any advice in this communication has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on any advice in this communication, consider whether it is appropriate to your objectives, financial situation and needs. You should obtain a Product Disclosure Statement or other disclosure document relating to any financial product issued by MLC Investments Limited ABN and MLC Limited ABN and consider it before making any decision about whether to acquire or continue to hold the product. A copy of the Product Disclosure Statement or other disclosure document is available upon request by phoning the MLC call centre on or on our website at An investment in any product offered by a member company of the National group does not represent a deposit with or a liability of the National Australia Bank Limited ABN or other member company of the National Australia Bank group of companies and is subject to investment risk including possible delays in repayment and loss or income and capital invested. None of the National Australia Bank Limited, MLC Limited, MLC Investments Limited or other member company in the National Australia Bank group of companies guarantees the capital value, payment of income or performance of any financial product referred to in this publication - 7 -