Cash

During the month the Reserve Bank of Australia (RBA) left the cash rate unchanged at 6.25%. The UBS Australia Bank Bill Index returned 0.5% for the month. Bank Bill Futures continue to price the likelihood of an additional rate rise early in the New Year.

Australian bonds

The UBS Australia Composite Bond (All Maturities) Index returned -0.3%, underperforming the UBS Australia Bank Bill Index (+0.5%) by 0.8%, as yields rallied, weighing on returns. The 3-Year and 10-Year bond yields ended the month at 6.1% (+16bps) and 5.9% (+29bps) respectively.

The economic outlook weakened during the month. Growth was at its slowest pace in three years as the drought, the worst in a century, cut output. Australia is forecast to grow at 2.5% for the financial year to 30 June 2007, significantly below the Treasury forecast of 3.3% in May 2006. The housing market also continued to slow. Home building approvals fell (-7.4% month-on-month) as higher interest rates weighed on the sector.

Despite the subdued economic outlook inflationary pressures dominated fixed interest markets. Inflation is tracking towards the upper end of the RBA's target range, at the highest level in three years.

International Bonds

The Lehman Global Aggregate Index (hedged, A$) returned -0.4% underperforming the Australian fixed interest market (-0.3%). Yields rallied strongly in all major markets as inflationary fears, muted in previous months, re-emerged.

The United States Federal Reserve left interest rates unchanged at 5.25%. The US 3-Year and 10-Year bond yields ended the month at 4.7% (+22bps) and 4.7% (+24bps) respectively.

The Federal Reserve noted that the "economy seems likely to expand at a moderate pace" in 2007 despite a "substantial" slowdown in the housing market. The bond market continued to question the degree that the slowing housing market would weigh on consumer demand. Previous decelerations in house prices have been accompanied by significant falls in consumer prices.

In Europe, the European Central Bank increased the interest rate to 3.5%, President Jean-Claude Trichet noted that inflationary risks remain on the upside. The Bank of England left rates unchanged at 5.0% despite inflation reaching the highest level in nine years. European 3-Year and 10-Year bond yields ended the month at 3.9% (+26bps) and 3.9% (+25bps) respectively.

European economic growth remains robust with the unemployment rate for the region hitting a 5-year low during the month. The unemployment rate (7.7%) remains significantly higher than in Australia (4.6%) or the United States (4.5%).

In Japan, fixed interest markets were subdued as economic growth remained flat and inflation rose less than expected. Japanese 3-Year and 10-Year bond yields ended the month at 0.9% (-3bps) and 1.7% (+2bps) respectively. Despite Japan's leading economic index increasing to a 4-month high, the economy grew less than expected in the third quarter with lacklustre growth in consumption. Japan lowered its economic growth forecast to 1.9% for 2006, and the economy is expected to grow at 2.1% in 2007.

Australian Listed Property Securities

The S&P/ASX 300 Property Accumulation Index was the best performing asset class for the month returning 7.2%. The best performing sectors were Retail (+7.9%) and Diversified (+7.4%). The worst performing sector was Commercial property (+3.7%). The best performing stocks were CFS Property (+12.8%), Centro Retail (11.7%) and Macquarie Goodman (+8.9%).

The sector is offering a yield of 5.5%, a discount to both the Bank Bill Index and the 10-Year bond rate. The sector has historically traded at a premium to both indices.

The inversion of this ‘premium' reflects the shift in the sector away from the buy-and-lease business model towards stapled securities where funds management and development activities are ‘stapled' with traditional property holdings.

International Listed Property Securities

The UBS Global Investors Index Hedged (+2.5%) underperformed Australian listed property (+7.2%). The best performing markets were UK (+9.6%), Japan (+8.9%) and Continental Europe (+8.2%). All regions recorded positive performance with the exception of North America (-1.6%), which accounts for over 50% of the index.

The UK market rallied in anticipation of REIT (Real-Estate-Investment-Trust) legislation that would come into effect from 1 January 2007.  The advantage of converting to a REIT structure is that the companies will no longer pay direct taxes on their operating income or capital gains.

The key driver of the listed property trust market has been the combination of legislative change (such as the UK) and strong investment flows into the sector. Record flows, combined with three years of double digit returns have driven down yields. This may weigh on sector returns in the coming periods.

While the sector continues to remain attractive, companies seeking to replicate the performance of the last three years in an environment of falling yields may have to assume development and/or funds management projects.

Australian Shares

The S&P/ASX 300 Accumulation Index returned 3.7% for the month.

The best performing sectors were Telecommunications (+10.8%) and Utilities (+7.7%). The worst performing sectors were Information Technology (-0.7%) and Materials (-0.2%).

Australian company profits rose less than expected during the month as Resource sector earnings moderated due to rising production costs. The RBA's commodity price index fell 0.2% during the month.

It was once again a month dominated by Merger and Acquisition (M&A) activity. Insurance Australia Group bought UK Equity Insurance ($1.1 billion). QBE bought UK Praetorian Financial ($0.8 billion) to double its sales in the US. ABC Learning continued its rapid expansion purchasing childcare centres in four countries ($0.5 billion). Fairfax announced a takeover for Rural Press ($2.1 billion).

The outlook for Australian equities remains highly leveraged to continued strong global economic growth, most notably in China and India. These economies in turn have benefited from strong US led (consumer) growth. This growth has started to moderate. The double digit returns, which occurred against the backdrop of soaring demand and corporate profits, appear less likely in the next phase.

International Shares

The MSCI World Ex Australia Index (net div in A$ hedged) returned 2.8%, modestly outperforming the unhedged index (+2.2%). The Australian dollar fell against the US Dollar (-0.2%) but rose against the Japanese Yen (+2.8%), Euro (+0.4%) and the UK Pound (+0.4%).

US (S&P 500: +1.3%) delivered a solid return as M&A activity continued. The Bank of New York purchased Mellon Financial ($16.5 billion), creating the world's largest custodian. Harrah's, the world largest casino company, accepted a takeover from private equity firm Apollo Management and Texas Pacific Group ($27.1 billion). The growing number of M&A deals drove up the price, not only of target companies, but of entire sectors as market participants speculate about the likelihood of additional bids.

Europe (MSCI Europe: +3.8%) registered solid performance. Germany (DAX: +4.6%) was the best performing major market while the UK (FTSE: +2.8%) was the weakest major market. German Business Confidence surged to its highest level since reunification in 1990 reflecting the renewed strength of the European economy and allaying fears that an increase in the Value Added Tax (VAT) next month would threaten growth.

The Japanese equity market (Nikkei 225: +5.8%) performed well as a weak Yen boosted the return of exporters. Despite moderate economic growth Japan's business confidence hit a 2-year high as export growth accelerated. The Ministry of Finance reported during the month that corporate profits rose at the fastest pace in more than three years.

Global Emerging Markets
The MSCI EM (in A$ with div reinvested) Index returned 4.7%.

The sector has benefited from continued demand for raw materials which account for 41% of the benchmark earnings. In markets such as Brazil, the Energy and Materials sectors account for half the market capitalisation. In Russia, Energy stocks account for 80% of the market.

The index is trading at a price-to-earnings multiple of 12x forward earnings. This multiple is lower than during the dot-com bubble when investor sentiment was high. Yet, the discount to the developed market has narrowed to 15% from 45%.

Emerging markets continue to receive record inflows with $21 billion invested in the sector in 2006, surpassing the 2005 record of $20.3 billion.