Late June and early July saw a surge in market sentiment, as various European Union entities and the International Monetary Fund apparently cobbled together yet another rescue package for Greece. Slightly more positive data also emerged from the US and Japan, where the post „quake recovery seems to be proceeding better than originally expected.

Some emerging markets are also taking comfort from the fall in the price of oil, even if this may itself be a symptom of weaker growth in developed economies.

However, we note that most of Asia has inverted to flat yield curves and that these have traditionally been good indicators of economic slowdowns and often recession.

We remain cautious and maintain relatively high levels of cash and bullion in our portfolios. We are sensitive to the degree of hedging  we have in  the VGT, ASV and  GDG, with some expectation  that the long  period of Australian dollar out performance may soon come to an abrupt end. Our problem is that it is not clear what currencies would outperform the A$ given the threats to developed world currencies.

Looking at another area of potential instability, the Europeans‟ political commitment to the Euro project seems increasingly untenable on economic grounds. Greece faces a significant restructuring of its debts, as the economy continues to shrink, while government debt spirals despite an unprecedented austerity programme. We doubt the Greek populace will have stomach for much more hardship, especially when it fully grasps that the current multilateral  so-called  rescues  are  more  focussed  on  protecting  bank  lenders  from  France  and  Germany  than helping the Greeks themselves. The real solution to Greece‟s problems is a default and withdrawal from the Euro allowing the restoration of the drachma and dirt cheap holidays in Greece for hard-working Northern Europeans.

We are no more optimistic on the prospects for two other sick small countries in Europe: Portugal and Ireland. The real test of the Euro and the European Central Bank will be bail outs for Italy and Spain, both of which have come under attack in the bond markets in recent days with soaring yields. Sovereign defaults by these two countries will have systemic impacts on the solvency of many European banks and probably the European Central Bank itself, and would put an end to what many commentators deride as the current “Extend and Pretend” routine in continental Europe.

Europe‟s problems do not end at the English Channel. Britain has the balance sheet of “Club Med” but the interest rates of the thrifty Northern Europeans. It still looks vulnerable, even before it feels the effects of the long overdue, but still painful impact of cuts in its bloated public sector. Given the shrivelled nature of its manufacturing sector, it is also not clear how much benefit it is getting from continued falls in the pound sterling.

The theme of weakening government tax revenues exceeded by rising government spending is evident in most developed economies. This is perhaps in its most extreme form in Japan, but it is increasingly apparent in Australia too, despite the well rehearsed, but increasingly unconvincing pledges to bring the Commonwealth budget back to surplus.

Where Australia stands out, and indeed looks more like an emerging market, is its willingness to use monetary policy to offset the fiscal laxity. Like developing Asia, Australia is seeing inflationary pressures. Unlike Asia, these relate more to labour shortages in WA and Queensland and rising government charges than raw material costs. Unfortunately structural inefficiencies in Australia prevent labour in the struggling Brisbane to Melbourne corridor flowing to the growth states as they have in previous resource booms. In the meantime the Reserve Bank of Australia‟s tough monetary stance is pushing up the Australian dollar, which adds to the pain in the mortgage belts of the large cities of eastern Australia through the destruction of traditional blue collar manufacturing jobs.

Increasing doubts about the sustainability of China‟s investment intensive economic growth model have seen many raw material prices plateau or dip. While it would be wrong to underestimate the capacity of China‟s central planners to keep the growth engines firing, signs are emerging that the conflicting need to put a cap on inflation through tougher monetary policy is putting the country‟s financial system under strain. What is clear is that if China does catch a cold, Australia, most of Africa and much of South America will get influenza.

The potential vulnerability of Australia‟s position is exacerbated by the increasingly apparent frailty of its housing market, which could have significant impacts on the country‟s banks, due to their high level of dependence on the sector. Australian banks have managed to slightly reduce their reliance on foreign borrowing, but still have high levels of loans to their core deposit bases. As well as having a huge traded sector, Australia is connected to the rest of the world‟s economy through our banking sector‟s reliance on wholesale funding to bridge the gap between loans and deposits. And if interest rates go up internationally Australian banks will be squeezed.  Any uncertainty about their financial strength will hurt the Australian dollar – and put the focus on the effective blank cheque the Commonwealth has written to protect Australian bank deposits.

How equity markets perform in this environment is not clear. We believe the 20 year bull-run in developed country government bonds is coming to a close and the inflationary impacts of lax fiscal and monetary policies in most developed economies are reaching an inflexion point. Rising costs of doing business in China will also remove the biggest deflationary force of this period caused by cheap manufactured imports. In our view, long term fixed interest investments are likely to do badly while equities are likely to do less badly.

We are of the view that the long swing of outperformance of Australian shares over foreign shares, especially when measured in Australian dollar terms is petering out. To this end, it is our present strategy to cut our hedges on our foreign holdings in the VGT, GDG and ASV as soon as we gain confidence in a decisive break in Australian dollar strength, and gradually cut our exposure to Australian stocks in the VGT as well.

At the country level we are still nervous about China, and fundamentally more bullish about India, especially if, as we believe, the recent monetary tightening phase is coming to an end, and recent oil price weakness is sustained.

The paradox of Europe is that great export companies from Germany, France, Scandinavia, the Benelux region and even northern Italy are benefiting from the currency weaknesses caused by the stresses at the heart of the Euro project. Japan contains elements of both the US and Europe so far as the prospects of individual companies are concerned, but seems frozen in even greater apathy at the political level, and in far too many cases companies there still treat shareholder as passengers rather than owners.

Meanwhile in the US, signs of a recovery in the housing market remain at best tentative, and even record company profits are not prompting much new hiring. At the same time most US governments seem incapable of cutting spending, with the only hurdle to increased indebtedness coming from mandatory debt limits at the federal, state and municipal level, increases in which typically require legislative approval.

Nevertheless, we do feel the US could be the one market that provides upside surprise potential. The one level where we have confidence is the ingenuity of corporate management, especially in companies with international sales, which are more likely to profit than lose from a weak currency and a soft labour market.

This is now being joined by an expansion in consumer credit in Q1 (the first since 2005); an improvement in US credit scores (which hit their highest level in four years in May); and senior loan officers willingness to lend is increasing markedly.

What if the best place to invest is the US and not Asia as many people think? This is not our base case given the sharp rises already seen in the market, the fiscal incontinence and coming budget issues, but food for thought if these can be addressed in a timely manner.

As our portfolio managers go about their work however the key remit remains unchanged from our inception nearly 20 years ago: to find stocks that are not just cheap, but cheap despite the quality of their businesses and managements and their prospects for growth.

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