UK: Outlook – Smith & Williamson Investment Management

Last Updated: 20 July 2010
Article by Smith & Williamson


Fiscal consolidation and the 'paradox of thrift'

In response to the sovereign debt crisis most European governments including the UK have embarked on a process of fiscal consolidation that will crimp budgets by 1% of GDP in 2011. While Europe pursues austerity the US has advocated the extension of stimulus. The divergence in view is stark and addresses the key macro economic debate – whether collective austerity programs will produce a 'paradox of thrift' whereby aggregate demand fades as both public sector and private sector deleveraging compound? While the dramatic decline in US, UK and German bond yields over the last couple of months could be partially due to their perceived safe haven status they could also be indicating a much lower trajectory of nominal GDP growth in response to the austerity measures. With little expectation of rising inflationary expectations, monetary policy is likely to remain accommodative in the US and Europe for an extended period. The euro zone economies have also committed to disclose the stress tests on banks when they are completed which could alleviate some of the pressures in the interbank market. The euro has staged a muted recovery from the lows seen in early June but remains vulnerable to renewed concerns over peripheral Europe.

China has seen several industrial disputes that have resulted in significant pay rises. The authorities seem relaxed about this as it is a mechanism to bolster domestic demand but clearly there is a risk of it igniting cost push inflation. Beijing has also intimated that it will allow greater flexibility in the Renminbi – gradually moving away from the dollar peg.

From the recent low on 25th May global equities staged a 6.5% rally but have subsequently retrenched as anxiety about the economic outlook grows. While the valuations on most markets are at the lower end of their 5 year historical ranges, sentiment over the coming weeks will shaped by the tenor of news flow as corporations announce their second quarter earnings and issue forward guidance.


A recovery but a lower nominal growth trajectory

The weaker than expected private sector payroll data in May revived concerns about the sustainability of the US economic recovery. These concerns might have been overstated. With annual productivity growth running at 6.1%, corporate US have pared labour costs to the bone and delivered extremely strong operating leverage. Balance sheets have been strengthened and aggregate cash holdings totaling $1.8tr (ex financials) are the highest proportion of assets since the 1960's. Consequently there appears to be scope for corporations to increase employment over the coming months which should support consumption expenditure.

Although some key leading indicators such as the ISM could be peaking and the housing market might dip in response to the removal of the tax credits the US economy still looks capable of delivering c 3% growth over the next few quarters. However, this would still constitute a sub par rebound from a deep recession.

The combination of declining headline and core inflation provides scope for the Federal Reserve to maintain its commitment to keep interest rates low for an 'extended period'. Also, the fragility of the European interbank market will militate against any change in the Fed stance.

Rising risk aversion on the back of concerns over the European sovereign debt position produced a rally in both the trade weighted dollar and the US 10 year bond yield. The latter could be establishing a trading range that could signify a lower long term nominal GDP growth trajectory.


Heralding the era of austerity

The remit for the Emergency Budget in June was to satisfy both the credit rating agencies and the markets that the UK has a credible and coherent fiscal consolidation plan that stands up to international comparison. It has fulfilled this requirement. Using forecasts generated by the new Office of Budget Responsibility (OBR) the budget outlined a reduction in net borrowing from 10.1% of GDP in 2010/11 to 1.1% in 2015/16 and the structural current budget moving into a surplus by 2014/15. This will entail an average 1.4 per cent a year fiscal contraction split 77% towards spending cuts and 23% towards tax increases over the course of the parliament. While the detailed spending cuts will not be clarified until the spending review in October the government has done a good job in recalibrating expectations in the public sector. The two principal risks are that there will be slippage in the delivery of the 25% cuts in real departmental spending and also that the growth projections for 2012/13 prove too optimistic.

While the May headline CPI at 3.5% and RPI at 5% both declined marginally from the April levels inflation remains stubbornly above the BoE 2% target. The increase in VAT from 17.5% to 20% in January 2011 announced in the Budget will delay the anticipated rate of decline in inflation. While there are some concerns that inflation is a consequence of a permanent decline in capacity and a smaller than expected output gap it still seems unlikely that inflationary expectations are about to rise sharply. Consequently monetary policy is likely to remain unchanged over the coming months.

Despite a precipitous decline in the BP share price due to the Gulf oil spillage the equity market managed to rally from the May 25th low but has recently started to retrench again. The 12 month forward PE stands at 9.8 x against a 5 year average PE of 11.4x. and the prospective Dividend Yield stands at 3.8%.


Equities benefit from the weaker euro

Fears over contagion from the sovereign debt crisis and tension in the interbank market in peripheral Europe persisted until mid June. In response to the growing pressure and fears over credit rating downgrades several EU governments announced fiscal austerity packages aimed at reining in budget deficits. The 2011 fiscal cut backs will account for 4%, 3% and 1% of Greek, Spanish and EU GDP respectively. In addition the Spanish government has embarked on a consolidation of the savings banks and has started to address labour market reforms.

In mid June the EU agreed to publish stress tests (when completed) on European banks. This proved to be an important turning point in market sentiment as it not only displayed uncharacteristic leadership but also offered the prospect of high level transparency. The euro rallied and sovereign bonds spreads over the German bund narrowed as short positions were closed out and risk appetite started to rebuild.

In terms of relative performance the Europe ex UK region experienced a reversal in early May. From the start of the year to early May the region underperformed by the same quantum as the fall in the trade weighted euro(c 6%). However, as soon as the emergency loan facility was provided in May the region started to outperform treating the continued fall in the euro as a positive. Net exports will be the key generator of growth for the region going forward and Purchasing Managers indices are already reflecting the benefits of the fall in the currency.

The key issue for Europe in 2011 will be whether the tough austerity measures will reduce growth. If growth forecasts do fall then 'Solvency' fears are likely to resume.

Asia – China changes its stance on the Renminbi


The US administration did not lose much time in voicing its disquiet at the posting of a big trade surplus by China in May. In response to this criticism Beijing has announced its willingness to accept greater Renminbi 'flexibility' indicating a removal of the peg and a shift back to a gradual appreciation of the currency. A strengthening currency would help reduce inflation in China and help re-orientate the economy away from export to consumption led growth.

The persistent problem in China remains the strength of the property market. Despite successive attempts at tightening lending standards the market has not slowed sharply and the China Banking Regulatory Commission has recently warned that there could be substantive losses on bad loans for Chinese banks.

The other big development in China is the emergence of labour unrest and industrial action that is resulting in substantial pay increases. The authorities seem relaxed about this as it is a mechanism to bolster domestic demand but clearly there is a risk of it igniting cost push inflation


After only 9 months in the job the Japanese PM Hatoyama resigned and was replaced by Naoto Kan the sixth PM in 4 years. The new administration wishes to establish debt- fighting credentials addressing the substantial primary deficit. It has intimated that it will double sales tax which could prove very unpopular. The fiscal strategy will be revealed over the next couple of months.

China is now Japan's biggest trading partner and any appreciation of the Renminbi would be beneficial.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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