Evercore Pan Asset

The car sales figures from Ford and General Motors in the USA yesterday showed that the recession is now hitting hard in America’s manufacturing heartlands. Tax cuts and lower interest rates gave the US economy a good boost to see it through the second quarter. There was still some momentum in the third, leaving the US ahead of the Europeans for the year to September. Now the intensity of the credit crunch is kicking in. We should expect a winter of job losses, factory closures and short-time working on both sides of the Atlantic.

The case for equity investment in the US, the UK and other mature markets is a simple one. Usually these economies grow. As they grow companies in general expand, becoming larger and more profitable. They can increase their dividend payments, or reinvest their profits for a good return by expanding more quickly. As they do so the value of the business rises. From time to time there can be a down year or two, but if you buy and hold over any reasonable period of time you will make money. If you own a bond, inflation will erode the value of your capital. If you own companies, they will overall go up by more than inflation.

Over periods of years in past decades this approach has worked. Yet if you look at the returns over the last decade, there have been more periods when this was not true. Indeed, if you invested at the peak of the markets around 2000 and sold again at the peaks in 2007 you would have made little as the peaks were very similar. Our work on returns shows that over the last decade it was possible to make good money from growth, as you would expect, by investing in the faster growth markets of Asia. This has been true despite the large falls in these markets this year. It was often not true of the advanced economies.

Perhaps sensing this, many larger funds moved some of their money into alternative investments. They bought hedge funds, commodities, private equity and property. Plunging commodity prices have heralded the drop in economic activity, leading investors who put a small proportion of their fund into this alternative asset class to question its current role in a portfolio. Private equity and venture capital markets are struggling. There is much less credit available for deals, and those deals that are taking place are happening at much lower valuations. It is very difficult achieving an exit, as the main equity markets do not offer an easy prospect of floating a company that has prospered under private equity ownership. Property values remain in freefall in the UK and the US. Many hedge funds have had a torrid couple of months, and some now face the problem of big withdrawals as investors head for the exit, forcing more sales of assets at low prices into an unwilling market.

The theory of alternatives was to provide some diversification. The hope was that these different asset classes would provide positive returns even when equities failed. In the last few months investors have discovered a sorry truth: All these investments – equities, property, commodities, private equity and hedge funds – need easy or expanding credit to flourish. All are damaged, some badly, by a severe credit crunch. Many Trustees and individuals have well-diversified portfolios that are nonetheless fair-weather or bull-market portfolios. They are suffering badly in this serious downturn.

So what should we make of this for the future? It is still the case that successful investment requires growth. In more normal times you will make more money out of equities and alternative investments than out of cash or bonds. It is also the case that most of these asset classes require some growth or at least reasonable access to credit, to provide positive returns. The issue for the sensible investors who have moved into cash, or who have some cash to invest, is which of these will be the best way of participating in some return to normality? This last week has seen some rally in world markets, as the huge liquidity supplied by central banks at last starts to filter through.

We remain of the view that you are more likely to prosper in the faster growing areas of the world. We remain worried about the UK, where excessive government borrowing comes on top of excessive private sector credit and heavy reliance on financial services. Funds that are still heavily exposed to the UK should switch some money out into stronger assets and economies. Some of the alternative asset classes will also be good investments in the months ahead. Care needs to be exercised about controlling risks and costs in these assets. Exchange Traded Funds (ETFs) can provide a more liquid, more transparent, lower-cost route to investing in them which gives a fund more flexibility.