Evercore Pan Asset

Pension and charitable funds share some characteristics in common. They both need to pay future wages. Their liabilities rise in line with the wage index or even faster. The sponsors would like the funds to grow faster than wages, so they can do more, or so it costs less to provide a given amount of help.

Normal advice proposes that these long term funds need to invest in assets with rising income. I have never agreed with the argument that buying a mixture of long bonds paying a fixed income can secure future pensions. The liabilities will go up, whilst the income from the long bonds will stay the same. That income in turn needs reinvesting, and the rate at which you can reinvest it becomes an important issue.

The advantage of equity investment is that in normal times equities give you rising income. For many years equities beat government securities, both because their income was rising, and because as the income rose so the share prices and assets owned rose in value. It was sensible to conclude that the asset that most matched the requirements of a long-term pension fund or charitable fund was equity. In normal conditions the income on shares would rise by at least as much as wages, and sometimes by more.

The last decade has not been a good one for this theory. Over the whole of the last decade investors in UK equities have now lost money, whilst holders of government securities have made money. Equity owners have not enjoyed their share of the growth in the economy, which performed well for most of the ten year period. We need to ask ourselves whether this simply makes equities cheap, or whether there has been some more important change.

You would expect equities to grow over the long-term in line with growth in dividends and with the economy as a whole. Dividend and earnings growth may at times exceed overall economic growth if the share of profits in the economy as a whole is rising. They might underperform if the share is falling. The first thing we need to look at is the long-term growth rate of the economy.

The UK economy grew faster than Euroland in the last ten years. It did so for a variety of reasons. These included a wider adoption of high leverage for banks, for property and for the general corporate sector. This use of high and rising leverage pushed apparent profits and activity levels up. The country experienced rapid inward migration of people willing to work flexibly, as the Eastern European countries joined the common labour market area of the EU. The UK was especially successful at attracting and retaining large amounts of financial sector business, which was itself pumped up by the excess credit being created.

These three factors are going to change adversely in the years ahead. For some time we will be working on a model with less corporate gearing, which will lower profits and dividends in the better times. The financial sector has to slim down considerably, as the excess credit is washed out of the system. Whilst the UK may remain a relatively attractive destination for migrants, the big rise in unemployment and shortage of vacancies may act as a brake on that. In addition, the transfer of more activity from private to public sector tends to transfer resources to less productive and less efficient uses.

There will be some offsetting trends that help. The current level of the pound, if it stabilises here, will offer exporters and import substitution businesses a better competitive edge. The temporary large expansion of government will offer some compensating demand for businesses.

The bottom line is likely to be a lower trend rate of growth in the decade starting 1 January 2009 than we enjoyed in the decade just gone. This is not good news for equity investment. Added to this, it is quite possible with two large banks nationalised and more activity in the public sector, that the share of profits in the economy as a whole will fall.

On historic yields of 5% the market is apparently cheap. If we could say that in a year or two’s time profits start rising again and dividends go up, this would be the steal of the century to buy equities on such high yields. However, it is very likely there will be substantial dividend cuts. The banking sector paid around one quarter of the total dividends paid out in 2007. Taken together the main banks cannot afford to pay any dividends. Some will do so, but they will seek the money from shareholders or other new investors in order to have the cash to pay out. The property and house building sectors will also need to husband cash. If oil stays around $40 a barrel or lower for any length of time the oil majors will have to go easy on the dividends. Many cyclical manufacturers are strapped for cash and low on profits at the moment. Most analysts agree there will have to be cuts of a third or more in dividend payments before this crisis is over.

If we could be sure the cuts will not be more than say 50%, and that shortly afterwards growth will be resumed, equities still look reasonable value compared to gilts on 3%. However, if growth is going to be lower, and if the share of profits in the economy is going to be squeezed, it all puts a bit more pressure on equities.

We still believe growing income is what pension funds and charities most need. We remain worried about the short-term prospects for dividends, as we cannot be sure how far they will have to fall, and about the growth rate thereafter. The UK economy at best is going to grow more slowly than in the last decade. At worst there could still be a nasty accident, given the high level of public borrowing and the state commitment to large and weak banks. We think faster growing income of a more reliable kind can be found elsewhere.

We have been recommending investment in Pacific basin equities on bad days in these dangerous markets. There we expect the recovery when it comes to generate much faster growth than in the UK, which should in turn lead to faster growth in company profits and dividends.