The risk factors that have been building through the year came to the fore in May. Firstly and most significantly, the problems is Europe refuse to fade away despite a series of proposals by policy makers to deal with the liquidity and funding needs of the countries facing a loss of confidence. The reason for this lack of respite is the concern that the key European nations and policy makers are still at odds over the right solution. In particular the ECB is reticent to move to a more aggressive provisioning of liquidity due to its fears over long-term inflation.

The second issue is the scale of the debt certain countries have built up which looks too high to be resolved through fiscal austerity alone. The market is therefore not prepared to park the problem for the time being until they see more aggressive policy measures to support asset markets and growth, or a more realistic solution to the solvency issue. Until this is resolved it will impact on business and consumer confidence leading to downgrades to growth, which has a flow-on effect to the global economy. It is also impacting funding markets, both by raising costs and by restricting availability, which has a flow-on effect to the rest of the banking system.

The market’s concerns on global growth have been elevated by a sense that the US, having been strong in April, hit a flat patch in May and also by the ongoing tightening in China. With respect to the US we are likely to see mixed data at this stage of the recovery.

We still believe that the strong position of the corporate sector combined with pent-up demand should lead to a reasonable investment-driven recovery in the economy in the second half. On China, the policy tightening has not been escalated from April; in fact the Chinese have explicitly acknowledged the risks in the global economy stemming from Europe, which will make them cautious to avoid over-tightening.

We still anticipate a 3 to 6-month window of aggressive measures targeted at property, leading to large headline falls in prices in tier one cities and triggering an inventory correction in certain commodities. We do not see this as a structural change in China, but as an opportunity to re-invest in certain commodity stocks.

On the domestic front, the proposed mining tax has triggered some significant reactions. Our observations are that the Government is combining tax reform with a significant uplift in the taxation of the sector. These two issues need to be looked at separately.

With respect to the reform, there is clearly a case to be made that the old royalty-based system can be improved. However the flaw in the current proposal is the assumption that the market will choose to value the ‘failure credit’. It appears this is not the case, which is most evidenced by the reaction of financiers to major projects. As a result the structure needs to be reviewed, whilst still maintaining the broad principle of a profit-based tax.

The second issue is the quantum of additional tax levied on the sector: this is material and leads to a 20 to 30% drop in the value of an existing coal or iron ore mine. This seems a large impost for one sector to wear and will clearly impact on the amount of money re-invested in the sector over time, particularly given tax regimes in other countries are more favourable. The impact from an investment perspective is to adjust downwards the valuations on the companies impacted. The more difficult assessment is the effect this will have on new investments and therefore the engineering sector.

Our conclusion is that projects already started will go ahead, but some in feasibility stages will get delayed until there is more clarity on the policy. Our exposure to the sector is orientated towards companies with a smaller amount of direct resource project exposure in Australia, for example Worley, which is predominantly operating offshore in oil and gas..

In conclusion we expect the uncertain environment to prevail for the near term, with a risk of issues in Europe being brought to a head to trigger a more aggressive policy response from the Europeans. It is important to note that such uncertainty brings opportunity and the portfolio is seeking to take advantage of the fall in the market to add to positions, particularly in companies which are not just relying on the cycle to see profits improve, but rather have specific opportunities to drive earnings. Examples are News Corp with their ability to get more value for their cable and network programming content or Asciano with their increasing market share of the Queensland coal haulage system.