According to Sarasin Group's latest Strategy Outlook, the combination of nervous central bankers and frightened politicians is adding up to ever more generous liquidity conditions, despite evidence of an accelerating world economic recovery. Isla MacFarlane collects Sarasin Group's thoughts on where investors can go from here
The authors of the report, Burkhard Varnholt, Chief Investment Officer, and Guy Monson, Chairman of the Investment Policy Committee, at Sarasin, said that global equities should continue to rise despite recent gains, as investors flee near-zero yields on cash. They noted that investor sentiment is further buoyed by central bankers' reluctance to turn off the stimulus taps.
The report said that, as a result, one of the most powerful rallies in risk assets in recent market history is being fuelled by extremely low interest rates and promising economic data. Export-led economies are experiencing a soaring inventory-led bounce, while unemployment in much of the world has not been as severe as economists forecast. There are still areas of concern - the US housing market remains too dependent on government support, while debate continues on the record levels of spare production capacity across global economies. These issues have increased the nervousness of policy makers about acting too soon to withdraw stimulus programmes and repeating the errors of the Bank of Japan in the mid-nineties.
Monson said, "The Goldilocks scenario - where growth is strong enough to lift earnings but too fragile for Central Bank tightening - that we dared to put forward in our last Strategy Outlook now dominates our strategy. As we expected, investors now have the confidence to escape near-zero cash yields. These yields are also encouraging investors to revisit equities given bonds' low yields. We are now taking a tactical approach given the unique up- and downside risks evident in the global economy."
Varnholt added, "Since the Goldilocks scenario has become a reality, we need to look out for the three bears. The first is the emerging markets questionable ability to offset a drop in US consumption, should this fall dramatically. The second is the inability of global economic powers to address the exchange rate regimes at the heart of global imbalances. The third is therefore a disorderly fall in the value of the US dollar as the currency loses its status as a global reserve currency and becomes a global 'carry trade' or funding currency."
Sarasin identified two key risks to global economic recovery. The first is that while consumption in the emerging markets will grow, it may not offset a fall in consumption in the US as saving rates rise there. While the easiest adjustment mechanism would be a revaluation of emerging market exchange rates, which would raise domestic purchasing power and productivity among thrifty consumers, this is unlikely. Sarasin said that it expects the dollar bloc to be bound by unsustainable exchange rates, leaving the G20 central bankers challenged by inflationary drivers that are contradictory and beyond their control.
The problem was elegantly described by Dominique Strauss-Kahn, the Head of the International Monetary Fund, in a recent interview with the Financial Times. He pointed out that lower American consumption, and with it a much needed hike in the US savings rate, would ultimately need to be replaced by another source of global growth.
"The US consumer will consume less; Chinese consumers, Indian consumers, Brazilian consumers will probably consume more. But will the second group offset the first one? It is not obvious," Strauss-Kahn said.
The report suggested that improving social safety nets and financial development would also work to reduce domestic saving rates, but these would likely take place over a much longer horizon. How likely are emerging markets, and China in particular, to move away from their mercantilist exchange rate regimes? According to Sarasin, the signs are not promising. Instead of moving the debate to the undervalued exchange rate regimes that lie at the heart of global imbalances, the global dialog has focused on fairly minor 'tit-for-tat' protectionist measures (ranging from Chinese tyres to US chicken exports).
Sarasin believes that in the next year or so, the signs are that the dollar bloc will continue to be bound by these unsustainable exchange rates. The report said that this imbalance suggests many of the 'disequilibria' in markets are likely to persist.
The report said that artificially high Chinese manufacturing capacity will at once bring about goods' price deflation and commodity price inflation. The challenge for G20 central bankers will be to set policy in an environment where a large part of the inflationary impulse is contradictory and outside their control. Moreover, as the domestic stimulus in the G7 leaks through higher import demand, the level of monetary and fiscal stimulus will need to be higher.
The second material risk that Sarasin identified is, therefore, a disorderly fall in the dollar as the American currency moves from the role of a global reserve to one of a global 'carry trade' or funding currency. Sarasin said that its holdings of physical gold, its underweight dollar positions and bias toward US exporters are all part of its response to these risks.
Sarasin is optimistic that economic conditions around the world are continuing to improve, citing the widely respected Philadelphia Business Index, which rose to its highest level in two years (well ahead of forecasts) reflecting similar recoveries in almost every regional economy. The report pointed out that the last three months has seen worldwide industrial production increase at an extraordinary 11 per cent annualised rate. The report found bright spots even in some of the darkest recesses of the world economy - for example, Investment Property Databank in the UK reported the first rise in commercial real estate prices since June 2007.
The report acknowledged that plenty of deflationary scars remain from the economic collapse and credit crisis of the last 12 months. Headline consumer prices are negative year-over-year in the US, Japan, China, Canada, Switzerland, and the Eurozone, with the UK one of the few developed markets to record positive data. Bank lending to the private sector is still weak and, despite a few positive months, house prices remain fragile in most Western economies. According to Sarasin, this tentative backdrop underpins the absolute determination of central bankers to continue deploying every possible reflationary tool. The most 'determined' statement came from the Swiss National Bank which declared that every possible weapon in its monetary armoury was available to keep liquidity conditions as generous as possible.
While Sarasin says that an exclusively reflation-based asset allocation stance is tempting, it recommends a broader, more tactical approach given the scale and duration of the rally to date, the rise in asset valuations and the existence of some unique up and downside risks. Sarasin said that it recommends a gentle reduction in corporate bond holdings, with long-term strategic opportunities in emerging market debt driving the use of sovereign issues and third-party EM bond funds.
Sarasin has also moved from a China-centric EM strategy to include South America, Eastern Europe, the Gulf, and, where appropriate, Africa. In China, Sarasin plans to focus on domestic growth themes, particularly related to consumer demand, education and healthcare. Finally, Sarasin said that it recommends a considerable exposure to equities, particularly financial stocks appropriate to its 'Corporate Restructuring' theme.
© Banker Middle East 2009
