How do you read the state of the markets at the moment?
It is much cheaper to buy calls on the upside than puts on the downside. Bell curves on stock markets are normal on the upside, but abnormal on the downside. There is hugely elongated tail risk. That tells me that investors are frightened, but not quite sure what they are frightened of! All types of asset are jumping from the “risk on” to “risk off” trade and back again. Clearly part of this is fear of deflation and a new banking crisis. But the main fear seems to be political risk. For 25 years, by and large, Governments and central banks have been trying to get out of the way of the markets. Now the risk is that they are going to be pulled in to a much greater extent.
You can see that everywhere. In the United States the midterm elections are going to be important. Will Larry Summers give the same advice to Obama that he gave to Clinton at the same stage and tell him to go for tax cuts? In Europe George Osborne is leading a tremendous intellectual battle over economic policy between Keynesians and Ricardians. On the one side you have the likes of Skidelsky, Krugman and Roubini arguing for more stimulus; on the other those like Rogoff and Trichet who take the classical Ricardian position that you can only get renewed economic growth by restoring confidence in the private sector.
It is very polarised. Some of the diatribes on the op-ed pages of the Wall Street Journal are quite vitriolic. The fact that there is nothing approaching consensus among the academics is disconcerting for investors. Given that some of the greatest minds we have are locked in a furious debate about the best thing to do, it is dangerous to take a high conviction global economic view.
Which side do you come down on in this debate?
Frankly I don’t know which academic school will be proved right in the end. I am happy to wait and see what happens. The UK is probably the laboratory of the world for the Ricardian solution. George Osborne has pinned us so strongly to the Ricardian route that it will be difficult for him to turn round. But the World Bank showed in a recent study that either policy can work. Countries like Denmark and Ireland, for example, successfully adopted the Ricardian solution in the 1980s. The Chinese have shown recently that Keynesian stimulus policies can also work.
What I do know is that these fears are creating lots of potential value. Equities should be rerating against bonds, but are being held back by fear of the uncertain policy response and the consequences of doing the wrong thing. Extremely low summer trading volumes (about 50% below the five year average for the S&P 500), exaggerated by quant and computer-driven trading models, have left the market paranoid about ‘macro news shocks’.
Over the last three months, according to Goldman Sachs, the S&P 500 has fallen by 80 basis points on days when major macro data is released, and risen by an average of 32 basis points per day when the economic diary is clear. They calculate that such a focus on ‘macro’ days is unusual and occurs typically after major market shocks (1988, 2002 and in late 2008).
What does that mean for investment strategy?
Fear of deflation and a new banking crisis doesn’t seem very rational. A double-dip is not the most likely scenario. Central banks could not have made it clearer that they will do whatever is needed in the way of monetary stimulus to avert a rerun of the 1930s. The Chinese authorities will come in if needed. Nevertheless high uncertainty is driving investors into the arms of the government bond markets, and condemning even the very best blue-chip equities to a frustrating market trading range, seemingly regardless of the quality of earnings or dividends they produce.
My hunch is that this won’t last for much longer. Either economic growth is going to stabilise, bond yields normalise and stocks rally, or else central banks will release more liquidity, yields will fall further and ultimately investors will buy blue-chip stocks for their balance sheets and yield. Investors should be starting to follow the natural progression, moving from money market funds to bond funds and then on to equities. Equities certainly look the most attractive asset class.
Global debt-equity valuations mean that bonds have become very expensive in relative terms. In fact, the yield ratio is close to the post Lehmann lows of March 2009, which itself was the 45 year low – lower than in 1974, 1979 and 1987. Corporate bond market spreads are mingy for the risk you have to take. As for emerging market bonds, unfortunately every man and his dog is already there. The main oddity in equity market valuations is that the higher the quality of the company, and the better its cash position, the lower the valuations. Rolls-Royces are selling for less than Volkswagens.
I think we are moving to a new kind of Nifty Fifty market, by which I mean a market where the best equities – companies with net cash, consistent dividends and strong cash flow – start to behave like high quality bonds. The free cash flow of large cap stocks as a percentage of GDP is now the highest since 1950. In three years time we could be looking back at stocks such as Novartis, with 11 years of dividend increases and growing at 7%-8% per annum, and see that they, rather than Government bonds, have become the risk-free asset.
Are you expecting new policy responses before (say) the end of the year?
While recent economic signals have been mixed, I think a double dip is unlikely, given the strong demand in Asia for consumer goods from advanced economies. Given that, further policy action from the Fed or the Bank of England is not our base case scenario. However, central banks will continue to err on the side of caution and if double-dip fears increase, the Fed first, and the Bank of England later, will no doubt resume their quantitative easing program.
How far is that already priced into bond and stock prices?
With the US Federal Reserve, the European Central Bank and the Bank of England all talking slower growth in H2 2010, government bond markets have already discounted all but a double dip. Barring some unexpected new crisis of confidence, Government bond yields may not visit the August lows again. That said, yields may well remain subdued until we have greater certainty for the economic outlook. We are still reluctant to purchase mid- and longer-dated government bonds at these yields because of the absence of convincing long-term value. Corporate bonds are likely to consolidate at current spread levels until an equity market improvement takes them on to a final tightening phase.
The irony of this economic uncertainty is that it is difficult to find it reflected in what appears to be an increasingly upbeat corporate world. Corporate earnings remain extraordinarily robust (up 37% this quarter in the US, with a near record 75% of companies beating estimates), with similar trends across all major markets. Despite a mountain of negative sentiment, global growth seems to be just about holding steady. Last month, the IMF upgraded activity for this year from 4.2% to 4.6%, which seems to be ample for cash-rich, extraordinarily lean global blue chips. Yes, the forward looking ISM index has started to roll over. US inventory levels are creeping higher, but our analysts are still seeing material thematic opportunities in global companies almost regardless of the economic backdrop.
Can you give some examples?
Nissan Motor reported its strongest quarterly operating profit in more than two years this month, as sales rose sharply in China and other major markets. The company sold a total of 954,000 vehicles in the first quarter of fiscal year 2010, which is an increase of 32% compared to the same period last year. Carlos Ghosn, president and CEO of Nissan, said: “First quarter results for Nissan are good and our recovery is vigorous and ahead of schedule”, supported by Nissan’s position in emerging auto markets, its expertise in smaller vehicles and a leading position in next generation electric cars, which provide rich future possibilities for the company.
The potential for rapid factory automation in China is clear, supported by both rising wages and manufacturers aiming to move up the value chain to produce higher quality goods. This long-term thematic growth is being captured by Fanuc, Japan’s leading robotics company. The Nikkei newspaper has reported that the company plans to increase its monthly output of robots by 70% by this autumn, to a record 2,500 units. Mitsubishi UFJ Securities forecasts that Fanuc’s sales to the rest of Asia will grow by 350% in second quarter of this financial year.
Sales of Android smartphones have grown from 20,000 per day in 2009 to 200,000 per day in July 2010 as the technology has captured mainstream consciousness and given consumers a genuine alternative to the iPhone. The shift from traditional mobile phones to these high-end, touchscreen handsets is occurring irrespective of the moribund economic environment. We have invested in this parabolic growth story via HTC, the Taiwanese smartphone maker. Sales of their powerful, irreverently branded touchscreen devices have leapt in recent months as the Android phenomena goes global. HTC’s revenues in July were up a remarkable 126% year-on-year, and we expect strong growth to continue. This seismic shift will have positive ramifications for data revenues, returns and profits in telecoms; a sector with enormously attractive dividend yields.
Even a traditionally cyclical stock like AP Møller-Maersk, which should be vulnerable to economic uncertainty, is reporting container volumes which are now surpassing the record levels of 2008. Its Australia and Latin Americas division saw volumes up 31% last year. We believe that AP Møller is better managed, better funded, has more efficient ships, and significantly more experience managing through cycles than its competitors, hence its place in our thematic stock selection. More importantly, though, fundamental changes in emerging market trade flows can, I believe, deliver earnings opportunities even if global economic growth should slow.
Do you have strong views on gold and currencies? If so, what are they? (Dollar, sterling, euro, yen, others)
I have no real strong views on currencies at the moment. We are seeing a competition of the ugly, everyone trying to keep theirs down. The USD and the euro are both close to fair-value. The EUR/USD parity will continue to move sideways. Sterling may be significantly undervalued, but a combination of low interest rates and tight fiscal policy will most likely prevent it returning to fair value for now. The yen is overvalued.
Most emerging market currencies are undervalued and as both inflation and growth are set to remain stronger than in developed economies, so too will their interest rates. Further appreciation of the EM currencies therefore appears on the cards. We are retaining our position in gold, but hoping not to make too much money out of it, as in that case everything else should be going up! But gold is insurance against a possible dollar crisis and so we will be hanging in there for a bit longer.
What changes have you made to your positioning in the last three months?
We have been reducing our bond duration and taking advantage of the dips in the stock market that seem to come round every 6-8 weeks to add more to our global Nifty Fifty holdings. We are starting to see a big shift into global equities by institutional clients, although as usual the retail investor is lagging behind. In alternatives our principal holding is gold. We are underweight in emerging markets but have increased exposure to our R and D stocks. Core names we own include John Deere; Foster Wheeler; SK Telecom in Korea; and BMW, which is getting extraordinary margins from its sales in emerging markets. Our international dividend fund has a 4.5% yield and dividend growth of 11-12%. It is proving very popular. Our general stance is to be cautious on higher risk investments for a while longer, and to be patient, sit back and enjoy the unusually strong cash flow and dividend growth of our cash-rich Nifty Fifty stocks.
For some slides on Sarasin’s latest views, click here [download id=”3″].
Jonathan Davis 