Evercore Pan Asset

2011 is proving to be a difficult year, lurching from bullish enthusiasm to bearish gloom all too often. This week there have been more worriers about. They have found plenty to concern them.

The year was clearly going to be one of rising interest rates and rising inflation. Many investors either chose to ignore that, or thought that nonetheless shares would go on up. After all, they argued, previous bull markets have taken place against the backdrop of some increases in rates and prices. As long as demand keeps expanding, and as long as companies can pass on the extra costs they are paying, all should be well. 
 
Suddenly these trends matter. Commentators and pundits are dusting down their articles on stagflation, an old term from the troubled 1970s. The prolonged riots and revolts in the Middle East are pushing up oil prices. The announcement that most of the technicians and foreign managers have now left the Libyan oil fields did not help sentiment any, even if Saudi is promising to make up any shortfall. The continued uncertainties over the government of Egypt leaves analysts concerned about the Suez canal and the pipeline that act as important conduits for crude. In the back of everyone’s mind is the possibility that these kinds of trouble could spread to the larger oil producing countries, and lead to further cutbacks in oil output. People worry in case we have higher inflation and less growth, the possible outcome from a sustained oil price hike. 
 
This week the Chairman of the Fed said that high oil prices for too long would have a negative effect on the US recovery. The Governor of the Bank of England tried to redress some of his pessimism about UK incomes and prospects when it was his turn to sit before a Parliamentary Committee. Market participants have new nagging doubts about the pace and durability of the recovery. if oil prices go too high, this takes spending power out of the oil importing economies, as well as driving prices higher and making higher interest rates more likely to curb inflation. 
 
At times like this it is best to go back to the obvious. Interest rates are very low in the US, UK and Euroland. One day they will have to go up. The US is unlikely to undertake more quantitative easing once QE II runs out this summer. Some of the recent market performance is on the back of this cash injection. India, China and Brazil, the big three emerging markets, are busily trying to put the brakes on, to get on top of their inflationary problem. If they are successful soon, they can then go back to more accommodative money policies which will help. If they are not, expect more aftershocks in the advanced world as the emerging markets slow their contribution to world growth.  
 
I do not see how the advanced countries can have good growth if the emerging markets dive through over enthusiastic measures to cut inflation, or through the spread of disruptive political action. We could be looking at a slower pace of advance as we get into the second half of the year.  The bulls need the violence and troubles to calm down, China to succeed in cooling without crashing, and the West to keep its nerve on money and interest rates despite the inflation now in the system. That’s a lot of things that have to go right. It could, but we think it’s right to hedge some of the bets. Chinese shares look good value, Indian shares are still pricey, and US shares are no longer a bargain. Having some cash and short term bonds is no bad thing. Cash gives precious little yield, but its market value does not go down.