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
