UK: Outlook, September 2010

Last Updated: 7 September 2010
Article by Smith & Williamson


The return of risk aversion

The demonstrable loss of momentum in the US economy combined with signs of heightened anxiety from the Federal Reserve over the risks of deflation has dominated market attention over the last few weeks. The catalyst for the deterioration in the outlook has been the sharp slowdown in job creation over the last 3 months and signs of fragility in the housing market. The Fed is clearly worried that the US economy is stalling. Bond yields have moved sharply lower in response to weak data and the rhetoric shift by the Fed appears to be factoring in much lower trend (nominal GDP) growth. It is worth recalling that the historical correlation between bond yields and nominal GDP growth is high. This has increased the pressure on the Fed to restart quantitative easing but they have stated they will need to see further evidence of a slowdown before enacting a new programme. Meanwhile, the Japanese yen has appreciated sharply as domestic savers repatriate their foreign investments in response to the heightened levels of risk and uncertainty in global markets. This adds to the deflationary pressure on the economy as it reduces the cost of imports and reduces net exports the main driver of growth.

In contrast to the US, the euro-zone has posted strong Q2 GDP growth, and a sequence of positive news flow. Despite this the European equity market has performed in line with the US market (on a local currency basis) emphasizing the strong correlation to the US market. The euro has started to retrench after experiencing a strong rally as the focus spins back towards the growth and debt profile of the peripheral economies.

While Q2 earnings were stronger than expected they have not produced substantial revisions to forward estimates and therefore have had relatively limited market impact. What has been more noticeable is the acceleration in the pace of merger and acquisition activity as corporations utilize their free cash flow.


Heightened anxiety

The observation by James Bullard the president of the St Louis Fed that the 'US is closer to a Japanese style outcome than at any time in recent history', not only raised the spectre of the US entering a deflationary trap, it emphasized the growing concern within the Federal Reserve at the loss of momentum in the US economy. This was reinforced by Ben Bernanke who mentioned that the US 'had a considerable way to go before it had made a full recovery'.

There are two primary sources of concern at the Fed. The first is the weakness in the labour market where only 150,000 private sector jobs have been created over the last three months. The expected three month run rate at this stage in the economic cycle should be closer to 700,000. The shortfall in job creation is unusual given the strength of corporate cash flow generation, and the breakdown in the usual transfer mechanism is perplexing.

The other area of concern is the fragility of the housing market. With an estimated 25% of US mortgages unable to be refinanced the housing market faces pressure from foreclosures and a significant inventory of unsold property.

While the Fed will leave rates unchanged for the foreseeable future it has agreed to reinvest the proceeds from the maturing mortgage-backed securities to purchase Treasury Bonds (at a rate of c$15-$20bn a month) – effectively maintaining the size of their balance sheet. However, they have not yet signaled rolling out a second phase of Quantitative Easing (QE2) but have kept the option open. Bond yields have fallen sharply in response to the combination of weak economic data and the prospect of the activation of QE2


A de facto shift in the Bank of England remit

While the latest Bank of England inflation report lowered UK growth forecasts for 2011 to 2.8% from 3.5%, these remain well above the 1.9% consensus forecast. This infers a downward bias to subsequent revisions. The report also forecast that CPI will remain above the 2% target until at least 2012, due to the impact of the rise in VAT in January next year. However, the Bank of England Governor Mervyn King, reiterated his conviction that the UK faces disinflationary headwinds due to a combination of a large output gap, weak credit creation and fiscal consolidation.

This stance is supported by signs that core inflation has started to decline and impending public sector cuts are already impacting economic activity. The decline in 10 year break even inflation from 3.25% in April to 2.5% at the end of August is additional confirmation that inflationary expectations will remain subdued.

The BoE is well aware of the dangers of a negative feedback loop emerging whereby talk of austerity reduces both confidence and activity. Because of this the BoE is de facto trying to shift their remit from strict inflation targeting towards a Fed style blend of growth and inflation targeting. Consequently, interest rates are likely to remain unchanged for a long while and as with the US Fed, the BoE has discussed the possibility of restarting Quantitative Easing if necessary.

The FTSE All Share 12 month forward consensus EPS estimates have flat lined since April but are still 22% higher than at the start of the year. This leaves the market on a prospective PE of 9.8X. The 12M forward dividend Yield of 3.9% is now higher than the 3.8% 30 year bond yield. The big question is whether in a low growth, low bond yield world, equities will need to yield more than bonds going forward.


A beacon of strength – but is it sustainable?

The euro-zone economy delivered 1% GDP growth in Q2 almost twice the Q2 growth rate expected from the US. Consequently full year 2010 consensus estimates have moved from 1.1% to 1.4%.

It is worth noting that the rebound in growth has been narrowly based and mainly reliant on net exports (principally German exports).

The recovery in industrial production and exports has seen a surge in business confidence and purchasing managers surveys. The hope is that this will soon translate into job creation and falling unemployment. Should this occur the recovery in the euro-zone will become both broader and deeper as consumption demand becomes the driver of incremental growth. This would also help transfer excess savings from Germany to the peripheral economies. However, it still remains to be seen whether the euro-zone can fully decouple its business cycle from that of the US.

The euro rallied between June and early August on the back of incremental improvements in both growth and interest rate differentials relative to the US, and also from reduced fears over the status of the banking system. Since then it has declined as attention has once again started to refocus on the solvency issue surrounding the peripheral economies.



The authorities in China have been attempting to slow the economy to a more sustainable growth rate by reining in the property market. They have done this by tightening lending standards and restricting the growth in credit creation. To this end, broad money growth slowed to 17.6% in July, compared with a peak of 29.6% in November 2009. House prices are showing signs of moderating having increased by 10.3% YoY versus a rise of 12.8% in April. Inflation moved back above the 3% target and might prove difficult to reduce as food price inflation persists. In order to counter balance the risk of export growth slowing sharply next year China needs to bolster consumption demand. This could be achieved via targeted incentives and allowing the revaluation of the renminbi.


Japan's GDP growth slowed to just 0.1% in Q2 as domestic demand turned negative, leaving net exports as the only driver of growth. Indeed since the recovery began in 2009 Q1 net exports have accounted for around 85% of the rise in GDP. Clearly the continued strength in the yen (the trade weighted yen has appreciated 17% YTD) poses a clear risk to export growth. There is also the additional risk that Japanese companies decide to relocate more production capacity overseas further curtailing domestic demand. The Bank of Japan is under increasing pressure to consider intervention to weaken the currency but remain reluctant to act. Excess spare capacity is still delivering persistent deflationary headwinds.

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.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.