Coordinated policy responses from governments and central banks around the world that provide liquidity and short-term funding to the financial system are not enough because risks to the real economy have increased, according to consulting firm Watson Wyatt.

In a note to clients, Watson Wyatt points to a tightening of credit conditions that will continue to exert downward pressure on economic activity and worsen the cyclical downturn, requiring further rate cuts in developed economies, expansion of liquidity facilities and more direct intervention in banking systems.

ôThe policy steps to date, despite being welcome interventions, have not been sufficient to facilitate the orderly function of money and credit markets, although there are small signs that this is changing,ö says Naomi Denning, Hong Kong-based head of investment consulting at Watson Wyatt. ôIt will be interesting to watch the various measures of credit risk and demand for liquidity in the interbank market during the next few days, which for the time being remain at extremes.ö

Watson Wyatt expects little prospect for a significant near-term recovery of the global economy, despite there being reduced inflationary pressures that give more fiscal and monetary freedom to policymakers. In addition to the financial risks, asset market trends have also reflected the economic risks, according to the firm, with rising bond prices and real yields, falling equity prices, the underperformance of cyclical stocks and a fall in commodity prices.

ôIt is too early to say definitively what the long-term impact of these interventions will be for institutional investors, but in the short term they have to be seen as positive to the extent that it has supported the banking sector, a cornerstone of the economy and provided some stability,ö Denning says. ôBetter to set them on a path to recovery, than allow them to languish at the mercy of jittery markets. Notwithstanding, policymakers, despite their best efforts so far, may be unable to avoid a deep and protracted global recession. That said, longer-term investors will be looking at some of the consequences, intended or otherwise, and possible opportunities, but it is not anticipated they will make any precipitous decisions on the basis of recent interventions.ö

Watson Wyatt advises its clients not to react to short-term poor relative performance from high-quality managers because it is often after such performances that these managers have historically produced stronger returns. It also cautioned against reactionary like-for-like manager changes because of recent significant increases in transition costs.

ôThe current crisis has clearly illustrated the problems of over-complexity of financial products and the growing likelihood of extreme market events,ö Denning says.