INVESTMENT FOCUS-The benefit of the doubt

LONDON, March 22 Fri Mar 22, 2013 11:31am EDT

LONDON, March 22 (Reuters) - More dogged than complacent, global investors appear determined to stay the course with equities, betting on a bumpy and protracted economic healing.

The first quarter of another turbulent year comes to a close next week with no shortage of potential prompts to cash in on what for some was a counter-intuitive bull run in the major stock markets to five-year highs.

Amid a messy bailout in Cyprus, inconclusive Italian elections and the beginnings of U.S. fiscal tightening, developed market equities have clocked up almost 10 percent in U.S. dollar terms since January 1.

But for all that the drama in Cyprus and elsewhere has put risk radars back on alert, and despite some unease about overcooked market prices, few strategists or asset managers are shouting 'cut and run' into the new quarter.

That's not to say they believe some correction is not possible or even likely, just that investment decisions in 2013 so far have largely been based on a bigger strategic picture than tactical trading on the daily or weekly ebb-and-flow.

"The biggest risk to our positive view on equities is simply how far and fast they have come already, and the fact that everyone seems to have jumped on the bandwagon," said Barclays Head of Research Larry Kantor.

But "with a supportive growth and policy environment and valuations that overwhelmingly favour equities over fixed income, we recommend that investors buy on dips."

The calculation is that as long as the world's major central banks continue to use super-easy monetary policy as the default tool to buoy damaged economies, then relative and historical valuations continue to favour equities over real losses in effectively yield-capped 'core' government bonds and cash.

The absence of panic over the Cyprus drama, which in prior years would have sent funds running for the investment bunkers, is revealing about those priorities if nothing else.

"Europe's valuation discount remains too high even with the region's complications and occasional dalliance with dysfunctionality," said Jeff Taylor, Head of European Equities at Invesco Perpetual. "Our valuation-driven investment strategy remains unchanged by Cyprus: overreactions are there to be exploited."

And the ease with which Spain on Thursday sold more than four billion euros of new government debt, at lower yields than previously, illustrates how confident investors feel that the European Central Bank can limit any systemic Cyprus fallout.

"New and disruptive systemic risks do not seem on the horizon, barring unforeseeable geopolitical shocks," Credit Suisse strategists told clients. "Equities' upside potential in such circumstances depends primarily on the path of real interest rates."

For the moment at least, the shock factor is not there for a marketplace now well accustomed to serial shocks over the past five years. For investors planning strategies in January, the 'event risks' that we've seen in the first quarter - Italy, Cyprus, the U.S. sequester - were already there in the diary.

While that doesn't guarantee a positive outcome, few could claim to be blindsided.

PATIENCE ON GROWTH

But is still-spluttering global and regional growth not cause for a rethink?

Record highs on U.S. stocks can at least be partly explained by a pickup in domestic growth there helped by structural tailwinds from a housing recovery and a manufacturing boost from cheaper shale-related energy prices - not to mention open-ended Federal Reserve money printing.

But there's little evidence elsewhere that raw economic growth rates alone are driving prices. If they were, then emerging markets would not be the big laggards of 2013 so far.

European economies remain largely stagnant, but the FTSEurofirst 300 index of the region's top companies is up more than 5 percent this year. Bellwether stocks of the still fast-growth emerging economies, meantime, have lost almost 2 percent on aggregate.

One reason for the divergence is that the big multinational blue-chips which dominate benchmark indices in the United States, Europe or Japan riff off aggregate global growth rates while many emerging markets are still dominated by exporters to the depressed West.

And while the global growth picture isn't necessarily pretty, it has picked up in the first quarter nonetheless.

Even as European business sentiment disappointed again in March, JPMorgan economists reckon worldwide surveys show global factory growth running about 2.5-3.0 percent annualised this month, underpinning their call for a jump in world GDP growth to 2.7 percent in the first quarter from 1.6 percent late last year.

So it's in the light of that sub-par but stable global, rather than local, picture that cheap valuations shine.

According to Goldman Sachs, cyclically adjusted price/earnings ratios for German and French companies are still some 30-40 percent below long-run averages, for example, while Spanish and Italian equities are more than 60 percent below.

And while it's possible these are fairly valued given the current regional ructions, Goldman reckons high Equity Risk Premia - gauges of earnings growth and dividends over alternative benchmark bond yields - are still attractive for long-term investors if the economy just normalises over time.

"Even allowing for a 125 basis point decline in margins over the next 10 years, we find current pricing is consistent with a long-term real total return in line with the historical average of 5.9 percent," the bank's strategists told clients on Friday.

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