Economic Newsletter

 dated 31 July 2008

From being ‘quiet pessimists’ over the last 18 months (and being right!) we actually think that a degree of both ‘realism’ and ‘pragmatism’ is returning to the UK economy which is healthy.  We were in the minority 18 months ago and sometimes felt isolated with our views on the economy and in particular housing being negative at a time when most commentators could see no end to the ‘good times’.

We welcome the return to fundamentals in the mortgage sector and the economy, accepting the short term correction is unlikely to please everyone, but is necessary for our future good health as a nation.

Newspapers are currently the news themselves being accused of exaggerating the bad times. However they were equally culpable of exaggerating the good times – repeated articles encouraging people to borrow to get onto the property ‘gravy train’ of wealth.

I am sure that you will not be surprised that the sensationalistic headlines in the media are an over-reaction to what was always inevitable. UK PLC has been due a correction for some time and this inevitably means an economic downturn. The ‘credit crunch’ is symptomatic of all that has gone wrong with banking, and is an accelerant or catalyst, for continuing woes.

Saving has become a dirty word. Previous generations were encouraged to be thrifty and save any extra they had in their pockets, whilst recently people been encouraged to spend everything and save nothing. They were encouraged to borrow what they did not have, to access equity in their homes and spend excessively as low interest rates and the low cost of living led to an extreme, probably once in a lifetime situation. A real problem that we face now is that the UK government was leading from the front, and doing the same!

What has changed?

The reality is that the UK had been on an extended growth curve and that the last part of this has been overdone.  It was fuelled by a number of factors; low inflation due to the emergence of low wage industrial economies, low interest rates, irresponsible excessive lending, high levels of hype and over-confidence at consumer and financial boardroom level, a strong pound, lax government fiscal policies, easy credit and excessive house price inflation.

So what has changed recently? Directly comparing the above issues we are now seeing much higher inflation in the low wage industrial economies, higher sustained interest rates, massively reduced lending, fear at consumer and financial boardroom level, a weak pound, problematic government fiscal policies, poor credit conditions and house price deflation.

Economic Outlook

I wrote last year that economists were concerned about the UK having a large budget deficit, high taxes and high levels of spending. A more prudent stewardship of UK PLC should have led to a nil or neutral budget deficit through the boom times of the last 10 years. There is no sugar coating here, and the current Chancellor has admitted that our excessive budget deficit will continue for the foreseeable future, and will have a detrimental affect on the UK for the next few years. There are rumours about the ‘golden rules’ being re-written to accommodate the required increasing levels of borrowing, which somewhat begs the question of what they are there for in the first place?

The ironic factor should be identified as the high levels of capital in the global economy from the emerging economies fueled by the ‘lifestyle’ of the consumers in the mature markets and their spending habits, which feeds back into the mature markets through investments, housing and spending as ‘they’ crave what ‘we’ already have, often increasing the value of what ‘we’ have! The UK needs to start spending its money in the UK and encourage other countries consumers to buy our goods – this relates to official trade figures for the UK which are in massive deficit.

Global inflation is high but it should start decreasing during the next twelve months as commodity, oil and food prices hit a ceiling for the time being, and some will start to decrease. In the UK, if wage inflation is contained, this means in 12 months from now, we could have inflation at or even below target! All this without the BoE doing that much as well! 

There are several downsides; commodity and food prices are likely to remain higher than they were. Whilst consumer spending and housing are falling through the floorboards, pardon the pun, this will reduce the tax revenue. UK PLC will therefore remain in bad shape for some time to come.  However, the weaker pound is making importing more expensive, whilst being beneficial to exporters and tourists, which should assist the economy.

Certainly, the government is either going to have to increase taxes or reduce spending over the next two years, or our budget deficit is going to get out of control. Expect this government to look for ways to reduce their spending through moves currently being announced as they have finally acknowledged that they have taxed the public as far as they can. Reduced spending could further suppress growth and increase unemployment.

One final comment! Although the West and particularly the UK, is experiencing financial turmoil, this is not the case for all economies. The emerging economies now account for a growing amount of the world’s annual GDP and although they are not totally immune from the turmoil, they offer investment opportunities. The Far East, Latin America, Central and Eastern Europe continue to provide exciting investment opportunities.  Our own experience in Central Europe is that there are still good opportunities to obtain growth.

As I wrote in September 2007 the global economic pressures that are stemming from the credit squeeze are affecting all of the four main asset groups. Thus, Equities, Property, Fixed interest and Cash, are all being affected.

Equities

We forecast an elongated period of volatility in the US and UK stockmarkets almost 12 months ago, and separately we felt that emerging markets were best avoided.

Let us now say we can start to see the light at the end of the tunnel. Do not confuse UK PLC doing badly for 2 or more years with our stockmarket doing badly for this time. Much of the FTSE100 are global companies that do not rely totally on the UK. The oil sector has leant support to our stockmarket, whereas clearly other sectors like transport, retail and banks are badly affected. However, banks are re-capitalising as I write this, and in 12 months from now the uncertainty will have been removed. Do not be surprised if the banking sector bounces!

We see a continuing volatile market but much of the anticipated economic worries have already been priced into the stock markets and it is uncertainty causing the issues now. Will there be another bank failure, for example? If you diversify, spreading your risk, and invest a portion of your money (not all of it) in certain sectors, or through diversified specialist collective funds, then you could well be very happy in 2 years from now.

Lets look at other regions of the world. The US went into this downturn first, almost 18 months ago (yes, that long) and the US has clearly got some way to go yet. We in the UK are at least 6 months behind the US in some areas, and even more when it comes to housing. However, Europe is behind the UK on this path with Denmark, Spain, Italy and Ireland now suffering. This domino effect is likely to continue in other economies as we work in a global market and the latest surprise was Germany recording negative growth.

Finally, commentators were noting that emerging economies would avoid the global downturn as they are detached from the existing mature markets. This is to simplify matters too much. The fact remains that the largest GDP area in the world by nearly every ranking is now the EU (including the UK). The second largest is the US. These two regions combined with Japan and Canada basically make up the majority of the worlds GDP.

Therefore, I find it interesting that I read that:

a)       If these key areas of GDP go into recession that the rest of the world can avoid it as the emerging markets are isolated; and,

b)       that in the near future emerging economies will take over as the financial powerhouse and brokers of the future.

This is unlikely to be in my lifetime, as I do not see the facts to support the arguments. China, India and Russia are powerful now but, even in the unlikely event they were to all co-operate together, it would still take years before they were bigger than the EU. That is to ignore the level of corruption, state intervention, poverty issues and political instability present in all three countries. Essentially, I do believe when considering the UK in isolation, that these countries present an economic threat, and unless the UK acts quickly we will become less significant, but as for a worldwide shift of economic power away from the US and EU in the near future, this is doubtful!

As we always have to say at this point, past performance is not a guide to future performance and your investment can go down as well as up. We retain the position that rising inflation in China and India is a concern; as is consumer confidence in the USA, the Russians new interventionalist tactics, and all these factors need to be monitored.

Remaining invested in equities with a long term view is still the correct position. Equities are good value at the moment and buying could be considered a good move. Diversification across markets, sectors and worldwide shares is a must of course.  Most long term investors are still better off; in some cases much better off, than when they originally invested over, say, a 10 year period.  You have to take the longer view with volatile investments.

Cash

In September 2007 I wrote, “Almost certainly we have reached the peak of the current interest rate cycle as a result of the credit crisis. However, as people have finally noticed, the actual rate at which cash is distributed and lent between institutions is actually the LIBOR in the case of the UK.”

The higher rates are also a risk premium for those institutions not doing so well. Fundamentally, cash is good if you are a saver at the moment (not allowing for personal taxation which can take up to 40% off the return) but it is not so good if you are a borrower, e.g. a variable rate mortgage holder. This will change as the financial institutions recapitalise and LIBOR reduces.

Property

We fought against the flow in 2006 and 2007 by saying property was about to become a poor investment. At seminars from 2003 to 2007, we conducted written research asking attendees what they viewed as the best performing asset over the coming 5 years – consistently the majority of attendees saw property as the asset to own! We would then comment on why we felt that property was never the superb investment above all others!

Residential Property

Everyone knew this was a boom, but they chose to rationalise it by finding reasons why it was ‘different this time’ and should go on up over ‘the next 20 years’ as some tabloids reported. Any boom has to be followed by a bust! The general public had simply forgotten, or chose to ignore, the lessons of the two previous crashes. Certainly, we find this when talking to people. In the press there is too much reliance on ‘experts’ (usually interested parties who have a vested interest in property)!