2 WORDS ********************EXCESS LIQUIDITY***************** Merrill sounds alarm on global liquidity By Ambrose Evans-Pritchard, International Business Editor Last Updated: 1:22am GMT 06/02/2007 Tom Stevenson: Investment column Merrill Lynch has warned of a global credit crunch as central banks in Europe and Asia tighten monetary policy, advising clients to shun risk and switch to safer assets over the forthcoming months. Presenting its strategy for 2007, the US bank said the world boom is clearly giving way to a slowdown that will shake up markets and punish smaller equities, industrial metals, and lower-tier assets of almost every kind. Money can still be made as the cycle turns, chiefly by rotating into short-term cash deposits and quality stocks with good dividend yields such as AstraZeneca, Barratt Developments, Sweden's retailer H&M, or Spain's Banco Popular Espanol - along with a few bars of gold bullion. The bank said 2007 would be the "year of the dividend", with fear returning as the VIX and VDAX volatility indexes - widely used in option trading - rise from record lows. "We think global interest rates are going to rise a lot more than investors are discounting, and this is a worrisome outlook for profits," said Khuram Chaudhry, chief European strategist. "We've seen liquidity everywhere, in equities, property, bonds. It's been a one-way bet for investors, and they've taken on a lot of risk. But they're not looking beyond the news to the slow drip-drip effect of interest rates. It matters when central banks tighten monetary policy," he said. advertisementThe US Federal Reserve has raised interest rates 17 times already since June 2004 from 1pc to 5.25pc, but Europe has been slower and the Bank of Japan is still holding rates at 0.25pc - offering hedge funds an alternative window of easy money. This last window is about to close, albeit slowly. Global liquidity - the monetary juice that fuels the system - reached a peak growth rate of 22pc at the end of 2005, even higher than the 15pc peak just before the dotcom bust in 2001. The rate has since plummeted to around 10pc, and may have further to go. Mr Chaudhry said the suddenness of the fall matters more than the absolute level, typically serving as a warning signal with a lead time of 12 to 18 months. It slid in a similar fashion in 2000, and before both the 1998 Asia crisis and the US Savings and Loan crisis in the 1980s. Merrill Lynch said it was cutting back on British equities, viewed as too exposed to resource, energy, and mining stocks that have already seen the best of the cycle. Britain is now one of the most heavily indebted countries in the world, leaving little scope for equity growth. Total loans amount to 162pc of GDP, compared with 111pc in the US and just 27pc in Poland. "The UK is going to struggle," said Mr Chaudhry. Merrill Lynch is betting on banks in Eastern Europe, a "trend growth" story for the medium to long-term with plenty of staying power as credit use catches up with the West. For those willing to dabble in Chinese equities, it suggests a switch from exporters to companies that serve local consumers as China's urban youth - Generation Y - catch the bug for western lifestyles. If in doubt, opt for the Chinese banks. They will fund the consumer revolution. Ultimately, no country is immune to a liquidity crunch if central banks tighten too far, as they often do. "We can debate whether it's going to be a soft landing or a hard landing, but the bottom line is that we face a landing," said Mr Chaudhry.