Evercore Pan Asset

In recent days governments around the world have come up with proposals for large reflationary packages of extra spending and lower taxes. At the same time we have heard about an additional potential $800 billion of support for the US banking sector, as the Paulson plan morphs for the fourth time. Governments are making it quite clear they will use every weapon in their armoury to try to lift the recession. We should expect more interest rate cuts, more financial support for banks and more adjustments of general economic policy.

The actions being taken are large and extreme. Markets remain very volatile, but still gripped by more fear than greed. Bears point to the continuing sales of shares from redemptions of hedge funds and other collective investment vehicles. They rightly warn us of more losses, dividend cuts and bankruptcies ahead. Commodity prices are well and truly punctured, and the private sector is generally slashing capital spending, seeking to conserve what cash they have. The western banks are still reluctant to lend.

Bulls also now have a case. They say that it now seems clear no more major banks will be allowed to go bust. Markets usually start to rise well before the bad news of the recession is over, discounting a year or so ahead of any upturn. Inflation is falling rapidly as predicted, interest rates will come down more, whilst the Asian economies will carry on growing regardless.

There are at least three possible scenarios from here. Because they are all so different, it makes investment judgement especially difficult.

The first is the official view of the UK and US authorities. They state that the recession will be short and relatively shallow. They assume the banks will soon start lending again, thanks to the extra capital and lower interest rates, the injections of liquidity and the supply of money. They expect inflation to undershoot, and then for the main economies to emerge with growth within their natural capacities. On their analysis, equities are a buy, as we are now half way through the downturn and looking forwards to a recovery.

The second is the pessimistic view that because the banking problems are not yet resolved, the recession is going to be much longer and deeper than the authorities claim. It is worrying that so far none of the conventional weapons of lower rates, more capital, more liquidity and government support have worked. The UK banking sector is still withdrawing facilities and putting up the price of credit. Partly this is because the regulators have demanded higher capital ratios, forcing banks to rein in their lending. Partly it is because bankers are now themselves frightened by the outlook and being understandably cautious about prospects for businesses and individuals. We could go into an era like Japan post 1990 where banking weakness negates many of the reflationary benefits of higher public spending, low interest rates and extra liquidity. On this analysis, government bonds are still good value because inflation is over and interest rates will fall to near zero, but equities will struggle.

The third scenario is that at some point all the reflationary medicine will start to work, in a way which could trigger a new inflation. There are always lags between changing interest rates and an economy responding. The UK and US authorities were around a year late in cutting rates, as we warned at the time. It will take several more months before you would expect much response. Because both US and UK banks were so weak, it takes time for those banks to repair their balance sheets and regain confidence to lend, but on this analysis it will happen in due course. If the banks did start to work properly again, there are huge amounts of liquidity out there which could start to pump through the system. Meanwhile Indian and Chinese demand for commodities of all kinds will continue to rise, exerting upward pressure on raw material prices. Both the UK and US authorities, so heavily encumbered by new debt, will have an interest in inflating their way out of some of it. This scenario is bad for nominal income bonds, but better for equities assuming the inflation does not get out of control.

The hazards of investing against this backdrop have kept Evercore Pan Asset cautious. We continue to regard the UK as too high risk, where mismanagement could create either a longer and deeper recession or set up the next inflation. The VAT cut was the least sensible way of helping in the current situation. It strains public finances even more, whilst offering little to lower income consumers who need to repay debt and save more. The government’s confirmation that it would be borrowing £157 billion this year including the banking investments which they leave out of the official statements, reminds us just how big a burden there will be on the gilt and National Savings markets.

We prefer the faster growing economies where public finances are under better control and where reflationary stimuli can be afforded, for some modest equity investment for longer term growth funds