Evercore Pan Asset

In the last few weeks there have been two important developments in markets. Shortly after we here, alerted you to the growing bubble in the prices of UK and US government bonds, the markets generally started to worry about the huge debt issuance programmes both governments are planning. The yields on longer dated bonds have risen, the prices of the bonds falling, as investors started to make some allowance for the sharp deterioration of government deficits on both sides of the Atlantic.

At the same time, markets moved from liking the idea of stimulatory packages to get economies going again, to expressing more scepticism, with further January falls in equity market prices. There was to be no first month market honeymoon for the new President, despite the upbeat rhetoric of “Yes we can”, the promise of millions of new jobs, and the gritty realism of the post victory economic analysis.

I think it helps to understand what is going on to remember that government are spending huge sums of money on two different problems. They are spending huge sums on buying new capital in banks, helping banks write down damaged assets and lending them money to keep them going. At the same time they are increasing government spending programmes and cutting taxes to try to stimulate more activity directly in the non banking sector.

Their supporters tell us both are necessary. They make the reasonable point that if they do not help mend the banks, the decline in the rest of the economy can get worse. If there are few car and home loans, and restricted working capital and investment loans for business, the general outlook will continue to deteriorate. If they do not stimulate demand by creating more jobs and spending on more projects, there may well be further declines in the value of loans on their books.

The problem is that trying to do both is very expensive. President Obama thought he could unite the nation around colossal state spending on both causes. The Republicans have dug in, opposing the magnitude of the spending, and the detail of the reflationary package. Opponents argue that more government spending means less private spending. In the first instance money has to be saved and put into government bonds, and later taxes have to be higher to pay for it all. What is the point, they ask, of switching spending from private to public? They also remind the government that the crisis hit because the US – and the UK – was spending too much and borrowing too much, sucking in too many imports. At some point the imbalances have to be corrected. You do not solve a crisis of too much borrowing by borrowing more, they argue.

Both the US and the UK authorities seem to be moving to policies of creating more money through quantitative easing, buying more bonds and increasing the Central bank’s balance sheet. This should filter through to asset prices and to activity levels in due course. The monetary decisions matter more than the reflationary packages. The decisions on general reflation and banking support are expensive and just mean a bit more inflation when the economies do come out of the downturn, and mean higher taxes for longer when the bills have to be paid. We continue to recommend good quality corporate bonds and selective equity market buying where investors have high cash positions.