Evercore Pan Asset

We expected the Bank of England to move to a second round of quantitative easing. Like the rest of the market we were surprised by the speed and magnitude of the proposal.
 
The Governor acknowledged that official inflation (CPI) will go up by more than 5% next month. RPI has been rising by more than 5% for some time. Real incomes have been damaged by the rapid inflation in energy prices and by the tax increases put through to try to plug the deficit. There is no current case for more money, as the money already out there is circulating rapidly allowing or causing price rises.
 
The Governor made two arguments for more QE. He first claimed that inflation will fall back next year. The Bank has been saying this erroneously for some time. We do agree that inflation should abate somewhat next year, especially when the VAT increases drop out of the figures. Commodity prices are moderating. We do not, however, foresee falling prices, the kind of scenario which might warrant extreme monetary action. We will be watching sterling carefully. If QE undermines the currency, then inflation will disappoint more.
 
He then claimed that we are in the worst crisis since the 1930s and maybe the worst ever. This invites the questions: Are we and if so, will QE help?
 
We believe the current crisis is very serious and long lasting. It does not seem as dangerous as the 1930s, given the offsetting growth still being experienced in many emerging markets, and the welcome absence of severe protectionism. More importantly, the current phase of the crisis is not characterised by deflation or falling prices. This crisis is more western than eastern, more advanced country than global. It is above all a debt crisis.
 
Some countries had over-borrowed private sectors – like the US, UK and Spain. This is being tackled in the usual way by a combination of borrowing less, paying down debt, and selective bankruptcies. Whilst this process continues these countries will experience lower private sector demand.
 
Some countries have over-borrowed weak banks. Ireland is on the way to sorting theirs out. The UK took state shareholdings in the two biggest weak banks and is still nursing them. The US combined state finance with selective bankruptcy in the 2008-9 period, which dealt with the worst problems for the time being. There remain some US banks to avoid.  Euroland argued that its banks were fine. Many now argue Euroland should take rapid action to recapitalise the weak ones.
 
Some countries are themselves over-borrowed and are running large deficits. So far the US and UK have got away with this. The crisis is hitting in Euroland, where over-borrowed states do not have the power any longer to buy their own bonds, to print money to pay the bills, or to devalue to help competitiveness.
 
We have long argued that the Euroland crisis is the most serious part of the picture. Yesterday the ECB did the minimum possible, offering more longer term lending to weak banks, hoping the politicians will this time get round to fixing the underlying problem. We see no evidence that Euroland has yet measured up to the magnitude of its difficulties. The danger is Euroland will create more bond losses and bank losses in the system. This will in turn pass on losses to US and UK banks that do business in the zone.
 
The right response yesterday from the Bank should have been a statement of actions being taken to minimise the risk of damage to the UK from any further Euroland banking and sovereign debt disaster.  The UK needs to sort out RBS.
 
What does this all mean for investors? It probably means for UK investors more inflation than we would like, and weaker sterling. It means the big bond bubble stays a bubble for a bit longer. The next set of government figures is likely to reveal continuing deficit disappointments and a large funding programme ahead.  It does not mean the problems are solved. For Euroland investors the ride will remain bumpy, and the best that can be hoped for is very slow growth with weak banks.
 
We recommend avoiding European investment.  It is still wise to be cautious and hold substantial cash.  The only more difficult question is how much collateral damage the continuing credit crunch in the west does to fundamentally stronger and healthier emerging economies. We still take the view that valuations outside the west are looking cheap, and that China will have to stimulate domestic demand to offset weaker advanced export markets.