06 - 11 - 08

A press-fuelled self-fulfilling prophecy; or simply the result of an unfortunate combination of events? There is, as ever, no simple reason how we managed to get into the current situation. But is it really fair to suggest that the media, in particular the influential BBC, have actually contributed towards the problem?

A press-fuelled self-fulfilling prophecy; or simply the result of an unfortunate combination of events? There is, as ever, no simple reason how we managed to get into the current situation. Certainly sentiment is a major factor in investment markets, as evidenced by the way stockmarket falls cascade around the world in a seemingly never-ending spiral. But is it really fair to suggest that the media, in particular the influential BBC, have actually contributed towards the problem?

A good timing for the BBC to serialise Little Dorrit?

Well to some extent, nobody can be absolved from blame, including borrowers, who have taken advantage of a sustained period of rising house prices to reduce personal saving and increase borrowings in order to spend (thus creating the engine house for economic growth). Equally the government only managed to pay for spiralling expenditure by increasing borrowing, rather than paying for it through unpopular taxation. And as for the banks, well perhaps we should say as little as possible about their irresponsible lending over the past decade or more.

Whatever the case, we are now half way into a recession, with a larger-than-expected 0.5% drop in gross domestic product, during the third quarter.

The Ernst and Young ITEM club is now reported in the Sunday Times (26/10/08) to be predicting GDP growth of 1% for 2008, -1% for 2009 and 1% for 2010. This may not sound too bad, but the average growth rate is ‘normally’ 2.75% a year, so by the end of the period we will be well behind schedule.

This has major implications for the government which needs economic growth if it is to be able to raise sufficient money to repay its borrowing without having to make unpopular increases to the rate of tax – or cut spending.

The worst is yet to come, but better times ahead
Some commentators say things will get worse in the economy, including a rise in the unemployment rate to, perhaps, 5% of the workforce. In the US, the rate has already topped 6%. But many also predict that this will be a ‘short sharp shock’ and that, provided that the Bank of England exercises the greater control that it appears to recognise is necessary, this could be the case.

Banks can no longer act like Ebenezer Scrooge

One of the keys to recovery is likely to be the behaviour of the high street banks. They must overcome their reluctance to lend to businesses or many could fail through lack of liquidity, rather than any inherent fault of their own. But they must also lend to consumers – albeit in a more controlled way than before – or demand will slow down too much and take the economy into even faster decline. Probity (prudence is a rather discredited word) must be the order of the day.

As an interesting corollary of this, banks are likely to need retail savers more than ever, as alternative wholesale sources of capital for them to lend have dried up and are unlikely ever to be as easily available as during the past five years. This could, of course, lead the banks to consider rather more carefully just how outrageously they treat their customers.

Interest rates and inflation

Banks must cooperate with each other or we all face dire consequences

Concerted action to cut interest rates around the world was probably the right thing to do in order to help bank liquidity. The Federal Reserve’s subsequent second cut within a month may not be the last we see, although a 0% rate (as previously seen in Japan) is unlikely.

But unless the banks start trusting each other again – which involves taking steps to understand the real value of assets backing thousands of securitised bundles of mortgages – this will not help hard-pressed homeowners or businesses. This is because LIBOR (the rate at which banks lend to each other) is still much higher than base rate. At the time of writing a 12-month inter-bank loan in sterling still costs 6.33%, which is 40% higher than base rate.

With the latest core inflation rate at 5.2%, the cost of borrowing needs to come down, as do energy costs (see “A plague o’ both your houses” below).

Markets (Data compiled by the Insurance Marketing Department Ltd.)
Anyone looking at stockmarket headlines during October will have seen further falls, largely based on ongoing uncertainty over the banking system and the impact this will have on economies round the world – especially when combined with recession. But the figures could have been much worse. The FTSE100, ended the month 10.71% down, but it had actually been 16% lower than this during the month. Likewise the FTSE250, which lost 20.36% during October, had been 11% lower late in the month. The Dow Jones fared worst, losing 28.49% of its value by the end of October, but had bottomed at a further 16% lower, earlier. European markets were also affected with the EuroStoxx50 ending the month 14.89% down and the Nikkei225, 23.83% lower.

Falling markets provide future opportunities

Interestingly the FTSE All Share yield is almost at a 12-month high, at 5.54% (during the past year, it has varied between 2.78% and 2.79%. Of course, this is partly an inverse ratio to the value of shares, but it also reflects the ability of companies to continue paying dividends.

Good news during the month has been the way oil prices have continued to fall – 32.21% in October – making the price per barrel for Brent crude 1-month almost a third lower than at the start of 2008. Interestingly, gold has fallen with prices losing 17.42% during October; when share prices fall, gold frequently gains value. This could be seen as indicating increasing confidence in the future of stockmarkets as gold is now worth almost a third less than at the start of 2008.
 
“A plague o’ both your houses”
OK, Romeo’s friend Mercutio was actually dying at the time, so he probably wasn’t thinking about the oil and energy companies. But his sentiments could well apply to the way these giant corporations are treating consumers at a time when oil prices have rapidly been skiing down the slopes from their recent heights; however, the threat of reduced production by OPEC could bring that to an end.

Why are gas and fuel prices not following crude oil down quickly enough?

It is interesting to consider whether a degree of price control over utilities and petrol/diesel might, however unpalatable in a free market economy, have some short term attraction. While calls for a windfall tax by some trades unions are probably unrealistic in such an integrated world economy – where tax regime ‘migration’ is so easy for large corporations – this option could certainly ease the burden for consumers and businesses. It could also ward off the very real threat of stagflation, which is inflation on top of a stagnant (or even shrinking) economy.

Sterling
With Sterling having lost almost a fifth of its value in just the last three months, we have been commenting that this will help exporters, but also has the potential to increase domestic inflation, as imports will become more expensive (especially oil, which is priced in US$).

Gambling against the pound may have reduced its value

However, if we start to focus on purchasing home produced goods, then the impact will be reduced. Of course, we still have to import most raw materials, but at least the “added value” created in the manufacturing process will be in sterling … and, more importantly, will help to generate (or at least sustain) jobs here. This is not trade ‘protectionism’. Nor is it neglectful of the very real needs of the third world to continue trading with us. But if, as the Prime Minister rightly says, the wealthy nations must continue to support those who are less well off, we need to ensure that our own economies survive first!

There is also the thought that a weaker pound will encourage Americans to come over here for holidays. Whereas during the 1930’s that was not an option, today the structure of the US economy means that there are many more people with the means to make such a trip.

A recipe for survival
The International Monetary Fund says that this is the worst crisis since the Great Depression. They may be right. But we can (and will) survive, if we follow a few basic strategies:

• Ensure that the banking system survives – for which much credit is due to this government;
• Avoid rapid inflation – by forcing down commodity prices and avoiding inflationary wage increases;
• Reduce consumer borrowing to a sustainable level – without forcing people out of their homes; and
• Ensure working capital is made available to businesses at an affordable cost.

We are confident of the future, but everyone needs to work together and the Chancellor’s decision to abandon his predecessor’s Golden Rules (including that borrowing should be only for capital expenditure over the economic cycle) is probably the right thing to do. Even if it allows the opposition to have a little fun at Prudence Brown’s expense. After all that is what politics is all about, isn’t it?

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