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Quarterly Newsletter - Spring 2008


The economic and financial climate during the first quarter of 2008 has been turbulent, to say the least.  So much has happened recently that Northern Rock has almost become a distant memory.  We have seen the meltdown of Bear Stearns, America’s fifth largest investment bank, who were then scooped up by JP Morgan Chase.  The oil and the gold price have hit new records, Eurozone inflation reached a 14-year high, the dollar continues weakening, and sterling versus the euro is heading towards parity.  The American economy appears to be in recession, ditto in Spain, Italy and Ireland, and there are fears that the UK might follow suit.

So, how have the stock markets reacted to all this?  Well, they took a sharp downturn at the beginning of the year, but they have recovered somewhat latterly.  Although the recent recovery is encouraging, we are not too sure about the outlook, and we think a double dip is perfectly possible.  Year to date, the performance of the major markets looks as follows: allindices are down, the Dow Jones by 4.1%, the S&P 500 by 6.3%, the Nikkei by 11.5%, the Nasdaq by 10.4%, the Dow Jones Euro Stoxx 50 by 15.1% and the Shanghai Composite by a staggering 40.2%! In the case of China, it really is a case of feast to famine.  

Against these falls, our own globally invested equity unit trust, CF Lacomp World Fund, has done comparatively well. It is down only 3.7%.  We thought you might be interested to read an article about our fund that was published byFund Strategy in their April issue, and we enclose a copy for your perusal. The Lacomp World Fund was launched in late 1999, in an effort to establish an independently audited track record of our performance, and we have never properly marketed that fund, using it merely as a core holding in some of our own clients’ portfolios.

We could go into great detail about the repercussions of the American sub-prime debacle, and how they affect the major economies and their stock markets, but we thought it best to concentrate on what is currently happening in the UK.  Plenty has been happening here!

It is just over a month since the UK Budget.  Having previously announced controversial proposals regarding capital gains tax and the taxation of non-domiciles in the Pre-Budget Report, the Chancellor was put under a lot of pressure to amend these measures.  In the end he did so, and one could not help feeling that some of the tax increases (for instance, the supposedly “green” new car tax regime) have been hastily cobbled together.  However, it was the Chancellor’s predictions about the outlook for the economy that worried us most. 

Rather than repeating what has been said in the national press already, let’s see what the experts have to say. The Institute for Fiscal Studies (IFS) probably is the UK’s best known independent research organisation.  Itemploys around 35 full-time staff of the highest academic calibre, and the full-time staff is supported by a network of Research Fellows and Associates from the UK and abroad.  There are also close links and collaboration with practitioners in tax and the law as well as with business and policy-makers.

Having listened to and analysed Alistair Darling’s Budget speech, their findings were pretty damning.  Here are just a few bullet points from the IFS’ Post-Budget Briefing:

  • The latest Budget is the seventh in succession in which the Treasury has had to concede that the outlook for the public finances is worse than it had previously thought.
  • Mr. Darling expects to have to borrow £20 billion more over the next four years than he thought in October.
  • The Treasury figures suggest an underlying deterioration in the public finances of £7-8 billion a year since October’s Pre-Budget Report.
  • All in all, there is danger that we are seeing the history of Labour’s second term repeating itself.  As you will recall, Gordon Brown insisted repeatedly after his forecasts began to go awry in 2002 that there was no problem with the public finances – but as soon as the 2005 election was won he announced a spending squeeze and introduced a series of tax-raising Budgets and PBRs.  If the 2008 Budget was not a good time to deal fully with the underlying weakness of the public finances, it seems unlikely that next year’s will be either.  If there is a fiscal repair job to be done, Mr. Darling and Mr. Brown may be leaving it until after polling day.

The last point is particularly pertinent.  Despite repeated protestations by both Gordon Brown and Alistair Darling, up to and including last week, that the economy remains robust and the public finances in good order, the reality looks very different to us.  In a nutshell, very large borrowing against a background of a major economic slowdown is highly likely to end in tears.

Readers of our Newsletters with good memories may recall that we suggested Gordon Brown, in his then role of Chancellor, might come unstuck by ditching his oft-mentioned “prudence” and forecasting what we considered over-optimistic future GDP growth.  That was exactly five years ago, and we are now seeing a repeat performance of that scene, albeit with a change in the lead role.

Digging even deeper into our Newsletter “memory bank”, in 2001, Gordon Brown forecast borrowing, over five years, of some £30 billion, which we considered optimistic at the time, and by 2004 that figure had increased to over £140 billion!

To be fair, it is not only the Labour Government that is guilty of what then FED boss Alan Greenspan, when commenting on the stock market boom of the nineties, called “irrational exuberance”. Governments – Labour or Tory – prefer to delay tough decisions, and they always seem to be extremely over-optimistic about the outlook for the public finances. 

In the mid-seventies, Labour had done the same thing, culminating in Denis Healy, the then Chancellor, having to go cap in hand to the IMF, blaming the malaise on inflation, which peaked at 11.8% in 1975, and unemployment.  In the eighties, the Conservatives, having inherited a deficit that they managed to turn into a surplus, nevertheless had to revert to huge borrowing after significant tax cuts and a slump in the economy combined to leave the public finances in a mess once more.

So, why should we be upset when faced with an equally unpalatable outlook now?  After all, is this not just history repeating itself?  Well, there is a distinct difference.  The Labour Government inherited a very strong economy when it came to power in 1997, and that economic boom continued both in the UK and the rest of the world.  After the Labour victory, we had many years of uninterrupted growth, and Gordon Brown was basking in the glory of being not only the longest serving Chancellor since the 1820s, but also presiding over the longest period of economic growth.  In the first two years as Chancellor, Gordon Brown kept spending tight, and borrowing was significantly reduced.  It would have been a perfect time to consider tax cuts, which most economists agree stimulates GDP growth, but instead he chose to increase taxation and start a massive spending spree on public services.  Tens of billions have been spent, and you can make up your own mind whether his increased spending has resulted in our having better hospitals, better education, better policing and better public transport.

At the risk of being considered a touch cynical, it is worth remembering that Gordon Brown did the usual pre- and post-election Budget trick: he increased taxes shortly after the 1997 election, cut them just beforethe 2001 election, only to increase them again in the subsequent Budget…

In addition, Gordon Brown has turned indirect taxation into an art form, introducing well over a hundred stealth taxes during his time as Chancellor.  Combine these stealth taxes with the increases in direct taxation, and it is no wonder that UK households have been subject to the biggest tax increases in the Western world since Labour came to power (source: OECD).  So, with all this additional taxation income being raised, you would expect UK plc to be in a pretty sound financial state.  Well, not exactly.  Unfortunately, we now also have the largest budget deficit of any major economy. 

Only last month, Public Sector Borrowing rose to £10.2 billion, thus significantly overshooting the consensus forecast of £7.8 billion.  This represents the biggest monthly deficit since the Office for National Statistics started keeping the figures in 1993.  Seeing that we are faced with a general slowdown in the economy, this does not bode well for the Government as they will receive less corporation tax, less VAT and, in view of dramatically reduced activity in the housing market, less stamp duty. 

Could it be that Messrs. Brown and Darling, realising that significantly less money would flow into the Treasury’s coffers, decided on a stratagem to balance the books somewhat by abolishing the 10p tax rate? Whatever the reason, they are now faced with a backbench rebellion, and even Government Ministers have been on the edge of resigning over this issue.  According to the IFS, abolishing the 10p tax rate will result in 5.3 million of the lowest earners (between £5,000 and £18,000 per annum) being worse off. However you look at it, this clearly flies in the face of socialist thinking which, after all, is meant to protect the weakest in society. 

When questioned on this topic by Andrew Marr on his Sunday morning show, Alistair Darling declared: “I attach considerable importance to making sure we help people on lower income.” Later on, he said: “I intend in future Budgets to return to this subject.” And later yet, he added: “Obviously, I will need to look and see what the overall fiscal position is next year.” Oh dear!

In his defence, Mr. Darling pointed to the increased minimum wage, the tax credits and the fact that he has taken pensioners “out of tax”.  Well, the minimum wage increase was long overdue, the tax credits are so complex that they rarely get claimed, and as for the pensioners…  Energy costs, council taxes, motoring and transport costs, medical insurance and other expenditure facing pensioners all have gone up quite dramatically, not to mention the cost of basic food items that have seen record increases over the last twelve months.

However, financial hardship is by no means the preserve of pensioners only.  Quite frankly, people of all ages find it difficult to make do.  In previous Newsletters, we have on several occasions warned about the historically low savings ratio and the high level of personal indebtedness (loans, credit cards and mortgages), quite apart from the national mountain of debt Gordon Brown was amassing. In June last year, during a House of Commons debate, John Healey, the then Financial Secretary to the Treasury, was questioned about the falling savings ratio.  This was his response (source: Hansard): “Households are benefiting from steady economic growth, and they are benefiting from low and stable interest and inflation rates.  The level of household savings ratio since 1997 reflects that stability, with households having the confidence to reduce their contingency savings, unlike in the early and mid-1990s.”

Three weeks ago, it was revealed that the rate at which families are saving has slumped to a 48-year low.  We wonder whether Mr. Healey today would still believe that it was people’s confidence in the way the country is being run that made them save so little.

The three recent interest rate cuts by the Bank of England did little to change sentiment in the financial sector inasmuch as the interbank lending rate (LIBOR) has hardly come down.  Moreover, the banks did not pass on the last two interest rate cuts to their customers either.  Basically, they use the slightly improved interest rate environment to repair their balance sheets.  As interbank lending has virtually dried up, mortgage providers have stopped offering 100% mortgages.  The offers they extend to homebuyers nowadays are far less attractive than they used to be, and it appears that this is unlikely to change in the immediate future. Alongside, credit card companies are putting up their rates, and this week a survey for the website MoneyExpert.com tells us that the credit card companies are turning down an average of 18,000 credit card applicants a day!  This suggests that people struggling with their mortgages are turning to plastic.

So, the aftershocks of the sub-prime crisis continue to rumble on.  Also this week, the Royal Bank of Scotland, the UK’s second largest bank, announced plans to raise funds from its shareholders through a rights issue of up to £12 billion to bolster its balance sheet. In addition, RBS is considering selling its insurance businesses Direct Line and Churchill, raising another £4 billion or so.  Having had to listen to Churchill’s bulldog going “Ooooh yes!!!” in their TV advertising campaign,  we might now get an “Ooooh no!!!”, or maybe it will just be a canine whimper.  With hindsight, RBS had spread itself rather thin by aggressively buying ABN Amro in 2007 (at a price many considered too high even at the time) and was therefore less able to cope with the effects of the sub-prime crisis.  Mind you, RBS is not alone in having to raise additional funds.  Both Switzerland’s UBS and America’s Lehman Brothers also have announced rights issues.  It is almost certain that others will follow that path. 

The Government latterly has been busy working with the Bank of England in an effort to provide extra liquidity into the financial system, and the Bank this week announced a £50 billion capital injection into the market, and that amount potentially could go up to £100 billion! It is hoped that this will encourage banks to start lending to each other again, and to do so at lowerinterbank rates.  What form does this capital injection take?  In essence, the Bank of England will swap treasury bills (bonds or gilts that can be readily realised for hard cash) for asset-backed debts that are currently “owned” by Britain’s high street banks.  However you look at it, this does mean that the banks will get “good” money in the form of government bonds, and the Bank of England will accept rather lower quality assets in return.  We did like the comment by the Liberal Democrats’ Shadow Chancellor, Vince Cable, when he pointed out that this was tantamount to the taxpayers having to shoulder the risks and losses of the banks.  He said: “We cannot have a situation where the banks are able to privatise their profits and nationalise their losses.”

Of course, the Bank of England is only lendingthis money to the banks, expecting it to be repaid within a year.  However, if one of the banks were to go belly up, the taxpayer would end up owning the collateral, i.e. the bank’s lending book in the form of mortgages.

Bearing in mind that the Government already has lumbered the taxpayer with an exposure to Northern Rock of over £100 billion, whilst at the same time refusing to backdate the police pay award, which by the way had been agreed by independent arbitrators and would have cost the Government a paltry £30 million, one has to question the rationale of these decisions. 

To quote Laurel and Hardy, the taxpayers could turn round to the Government and say: “Well, here’s another nice mess you’ve gotten us into!”

STOP PRESS! As this is being written, we hear that Gordon Brown, being faced with the prospect of the Government losing the vote on the abolition of the 10p tax rate, decided to do another U-turn by promising moves to compensate pensioners, young people and childless people on low incomes who would lose out from the 10p tax rate’s axing.  Clearly, Gordon Brown caved in under pressure from his own backbenchers.  The opposition parties were quick to make political capital out of this latest U-turn, with David Cameron accusing Gordon Brown of “weakness, dithering and indecision”, and Lib Dem leader Nick Clegg calling Mr. Brown “increasingly pointless”.  Oh dear!

 

23rd April 2008

 

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