Sarasin Strategy Outlook: Political risks and policy divergences leave case for compelling valuations undiminished

In its latest Strategy Outlook, the Sarasin Group contrasts the policies and actions of double-dip fearing central bankers in the West with inflation-fearing policy makers in the East. Added to this, an oil price shock in the last quarter and ongoing disruption to global supply chains in the aftermath of the Japanese earthquake and nuclear disaster helps explain why financial markets are having a bout of nerves, says the Sarasin Group. However, it points out most equity indices remain in positive territory for the year, while market volatility is just a fraction of the level seen in previous crises. With another quarter of strong earnings and dividend increases behind us, as well as near-record corporate cashflow, the Sarasin Group continues to highlight global blue chip equities as the asset of choice for 2011.

A micro version of the dilemmas facing double-dip-fearing bankers in the West and inflation-fearing policy makers in the East is playing out in Europe; surging growth in the core is meeting a near complete breakdown in the Greek debt markets, warnings of downgrades for Italian bonds as well as renewed political and economic strife in the rest of the European periphery. The European Central Bank (ECB) has found itself most uncomfortably in the middle, advocating further budget consolidation from the periphery and more financial transfers from the core. The Sarasin Group indicates that it is likely the ECB will have to prepare for some measure of restructuring of Greek and potentially other peripheral Europe debt with the probable proviso that this is accompanied by further fiscal transfers from the core to the periphery.

Guy Monson, Chairman of the Investment Policy Committee: “It’s not just markets, but central banks that are also acutely sensitive to signs of economic weakness. Overstimulation is the stated objective of the Federal Reserve to ward off deflation: there is simply too much at stake to risk a premature exit. If current signs of economic weakness persist, then we expect the Federal Reserve to not only push back any timetable for exit from quantitative easing, but also look for new ways to stimulate growth.”

Burkhard Varnholt, Chief Investment Officer

“In spite of contrasting economic scenarios between East and West, the global equity earnings machine simply continues to march on, with another estimate-beating quarter of earnings matched by some stunning dividend rises and cashflow forecasts. Our policy therefore remains the same, with global blue-chip equities continuing to be the best each-way bet in the face of policy uncertainty.”

In Asia and the emerging world, on the other hand, fear of inflation and the crippling costs of subsidy programmes to protect consumers from higher energy costs have given way to tougher money policy and a greater tolerance of currency appreciation. Bank reserve requirements are being tightened again, interest rates are rising, and politicians are speaking of the risks of inflation almost daily, despite the partial correction in energy and commodity prices over the last weeks. The Sarasin Group expects further monetary tightening which should lead to a slowdown across the region.

The Sarasin Group concludes that the fact that equity markets have only retraced their gains of this year seems a rather modest result in the face of such challenges, especially as market volatility has remained at just a fraction of the levels seen after the Lehman crisis or the first Greek bond collapse. Much needed falls in commodity and energy prices have helped and will continue to do so.

Investment policy implications

Rising political uncertainty, fluctuating food and oil prices and the threat of higher interest rates are not the classic indicators of strong investment markets. They certainly carry risks for global fixed-interest portfolios, and for highly-rated equity and real estate assets in the emerging world. But, as the Sarasin Group has indicated for some months, global blue-chips remain cheap and should be able to survive this temporary slowdown, while global growth rates are still powerful enough to support corporate profit growth.

Deleveraged economic recovery, coupled with ultra-conservative companies, is supportive of both dividends and tighter credit spreads. With today’s ultra-tight spreads the Sarasin Group is starting to reduce corporate bond exposure, with the exception of tactical bank holdings.

Although the Sarasin Group expects a Greek, Irish or Portuguese sovereign restructuring to bring significant volatility into the markets, it regards a Greek default as likely to be a relatively modest earnings event for European blue-chip names with little long-term impact on Tier 1 ratios. This is not to say that local banks and second-tier names could not suffer significant capital depletion, potentially leaving some embracing government assistance.

The recent pull-back in markets has led to most major equity markets trading below 20-day moving averages, and while Sarasin is conscious that this correction may have further to go, it now sees opportunities to add exposure at today’s market levels, encouraged by the remarkably low levels of market volatility across all global indices. Corporates are in rude financial health. Margins across the board are improving, and set to improve further into 2012, as companies continue to take costs out of their structure, and as operational leverage kicks in. Mega-cap equities may be starting to end an almost 12-year run of underperformance versus mid-caps, supported by relative price-to-cashflow valuations well below the long-term average, making these blue-chip names particularly attractive.

Oil prices and volatility in the oil market are likely to remain strong in the absence of clear production increases. If supply conditions do improve, the tentative ‘beginning of the end’ of the near decade-long energy bull-market could be at hand.

The Sarasin Group’s currency projections continue to indicate a modestly oversold US dollar, despite the strength of the last few weeks. A modest weakening of the yen is encouraging, but further intervention should not be ruled out. Small but regular increases in the Chinese currency look set to continue, allowing other Asian currencies room to appreciate. This is positive for the earnings of US and European exporters.