Is the credit crunch just a bump in the road or a serious hazard precipitating a long-term crash?

A St. Andrew’s Day Celebration event, hosted by Baillie Gifford at the Sutton Place Hotel in Toronto on Nov. 27, 2007, examined possible future outcomes of the ongoing liquidity crisis. Ken Barker, Investment Manager with Baillie Gifford, presented arguments for both “bearish” and “bullish” scenarios.

The “bear” case paints a very dark picture. The problems in subprime could lead to a host of other problems afflicting world markets, such as the collapse of housing prices in the U.S., the U.K. and possibly other parts of Europe, a slump in consumer confidence and low spending causing the collapse of company earnings and the lost battle for liquidity leading to the monetization of debt. The bleak outcome of this scenario is the downward spiral of the U.S. dollar and a “1970s-style stagflation,” says Barker.

However, Barker believes it’s unlikely that the worst-case scenario—a coincidental recession across the globe—will come to pass. Losses from the credit crunch are still relatively contained, emerging markets are thriving and we’re still seeing high employment and global growth in gross domestic product. “Central banks will cut rates if they need to and will certainly, I’m absolutely sure, maintain liquidity at all costs,” he affirms. “Recapitalization could happen,” he says, as there should be enough cash available globally to make it work. “

So where do we go from here? Barker offers three main recommendations to the investment banking system to generate a more positive outcome. One, it should “mark to market” properly, since not doing this can lead to bad judgment calls to cover up losses. Two, it needs to “de-lever” and acquire capital—potentially from emerging markets, which have become one of the main providers of capital. Three, it needs to rediscover “the art of credit analysis” and sound decision-making. As Barker says, “most of it is simply common sense.”

Barker also has several suggestions for investors. He proposes maintaining a neutral-to-bullish attitude toward interest rates, since central banks may have little choice but to cut rates in the future. He suggests buying credit, since many companies may have already overcompensated for credit risk. He supports overweighting in financials, which he sees as “the best value within a valuable market,” as well as buying the equity of the monoline insurers. But generally, he advises caution with regards to investing in equities, since he believes that profits are ahead of long-term trends and could fall in the future. Finally, he encourages a bullish approach towards emerging markets using an active investor, since many of these markets are now producing capital and could potentially be at an “epoch-meeting tipping point” with developed markets.

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