In this week’s bulletin:

  • The reaction to the Coalition’s Emergency Budget was that, it was not as bad as previously feared – the Chancellor George Osborne is looking to public spending cuts to bear the burden rather than higher taxation
  • All eyes were on the bond market following the Budget and John Hamilton, gilt manager at Jupiter, explains the messages conveyed by bond investors to the UK government.
  • After an initial surge following China’s decision to decouple its currency from the US dollar, financial markets become more cautious as the week progressed, with worries resurfacing over the stability of some European banks
  • Ben Bernanke, US Fed Chairman, gave a downbeat assessment of the outlook for global recovery following poor news from the American housing market but re-iterated his pledge to keep interest rates lower for longer
  • By the end of the week most equity markets ended lower with London weighed down by BP’s woes in the Gulf although sterling ended higher as investors responded to the Budget and interest rate outlook.

Tax & Axe
The dire warnings that presaged the Emergency Budget worked splendidly for the Coalition – when the Chancellor, George Osborne, finally delivered his first Budget the collective sigh of relief was palpable. The immediate reaction of the vast majority was that it could have been much worse, despite the vast numbers that Mr. Osborne churned out – £113,000,000,000 to be precise. This is the total of the spending cuts and tax increases to be imposed by 2014-15, representing £4,300 a year for every household. In deciding how to carve-up the savings the Chancellor opted for a 75:25 split – with spending cuts bearing the largest percentage – even though he has long argued that international experience recommends a more familiar 80:20 split. The Institute of Fiscal Studies opined that having inherited a 70:30 split from Alistair Darling, Mr Osborne decided to split the difference with the Liberal Democrats. The contents of the Chancellor’s red despatch box were shared freely and even-handedly too: everyone will contribute to the huge cost of clearing up the public deficit in some shape or form, be it via higher VAT, income and capital gains taxes, welfare cuts or pay freezes.

There were no hiding places either for Britain’s largest banks that are set to pay the vast bulk of a new £2bn-a-year levy that was announced – all but the smallest building societies will have to pay 0.04% tax on their balance sheets, although this was less than feared. Indeed it transpires that this will mostly be offset by a larger-than-expected reduction in UK corporation tax from the current 28% to 24% in four years’ time. The government’s strategy could be ‘kill or cure’ for the UK economy thought The Financial Times, predicated on the country being able to sustain a successful recovery while savagely cutting public expenditure, shedding tens of thousands of jobs and hiking consumption taxes. Whilst in line with most economists’ expectations, opinion is divided over the impact the measures will have on prospects for growth in the years ahead.

Bond Market a Winner
The bond markets notched up another victory in George Osborne’s Budget – after forcing austerity packages on half of Europe, gilt investors got exactly what they wanted from Britain too. Bond manager John Hamilton, of Jupiter, explains why.

“In Greece they burnt banks, in Spain they demonstrated on the streets, but in the UK they carried on watching the World Cup. That’s one explanation for the lack of movement in ten-year gilt yields following the coalition emergency Budget. The other explanation is that the Budget fulfilled expectations. This is encouraging. It is now clear that the Chancellor does not want markets asking any awkward questions about the UK’s financial health which might threaten its credit rating and hence the cost of issuing new debt. Although we are still issuing a lot of debt, planned gilt sales for 2010/11 have been revised downwards by £20.2bn to £165bn following the Budget and the Debt Management Office has cancelled three gilt auctions. This was roughly what the market had expected.

“Since the election last month, the bond market has given the new coalition the benefit of the doubt. Ten-year gilts have rallied and their yield has been stable at around 3.5% on the assumption that the emergency Budget would be credible. It was. In April the European Commission criticised the previous Chancellor’s Budget saying that, although it outlined plans for fiscal consolidation from 2010/2011, it did not present a medium-term objective for the budgetary position that would put public finances on a sustainable footing. This Budget corrected that problem by aiming to eliminate the structural deficit by 2014-15. As Governor Mervyn King reminded Chancellor Osborne in his recent Mansion House speech, in the medium term, it was important that national debt as a proportion of GDP returned to a declining path.

“One popular theme among commentators has been the battle between the Keynesians and the monetarists: if harsh cuts are made when the economy is still fragile, then this could trigger another downturn. Alternatively, if fiscal retrenchment is delayed the economy is left exposed to the vagaries of the international bond markets and credit rating agencies. Since all budgets rest on growth estimates, the new coalition has got around this problem by creating an independent Office for Budget Responsibility to endorse its actions. The OBR has now confirmed that, apart from a reduction in growth in 2011 (from 2.6% to 2.3%), in its view, the Budget measures are not so harsh as to derail the prospects for economic growth in the years ahead.

“Where do gilt markets go from here? In the short run, having priced in the Budget measures, the path of inflation now becomes more important. The risk is that, with ten-year gilts yielding 3.5%, a favourable inflation outlook is already in the price. Nevertheless, in the long run, the disinflationary background is still there”.

Chinese Whispers
Last weekend China announced that it was to adopt a more “flexible” approach to the management of its currency – seen by cynics as a sop to the US ahead of the G20 meeting this weekend. On Monday, investors took a more optimistic view that any gain by the renminbi (or yuan as it is also known) against the US dollar – to which it had effectively been pegged since 2008 – would be positive for global growth by helping increase exports to the world’s second largest economy. On the back of this, China’s currency surged to its largest one-day gain against the greenback in five years; gold jumped to a record high, while a number of other dollar-denominated commodities including oil, copper and aluminium also rose sharply. Global equity markets joined in too, with shares prices rising smartly at the start of the week – the one most notable exception was BP though where the Gulf imbroglio became ever more serious for the oil company. At one point its shares fell below £3.00, some 50% or more down from when the crisis started, as investors feared the worst on news that the company had sought commitments from banks to lend it more money.

But as the week wore on, the markets’ optimism over the renminbi ebbed as old fears returned – namely concerns about the eurozone banking sector and the pace of US economic recovery. Comments from Christian Noyer, an ECB governing council member, saying that “some [European] banks have started facing increasing funding problems” percolated around the market, heightening nervousness that concerns about eurozone sovereign debt were translating into interbank tensions. ECB policymakers have long worried that some banks have become dependent on the unlimited liquidity it has pumped into the market, which stands at record levels. Apparently banks in Greece, Portugal, Ireland and Spain account for more than two-thirds of increased lending by the ECB as they struggle to access financial markets. Nick Matthews, an economist at RBS, which compiled the data from eurozone central banks, said “This is a sign of stress in the system. Banks do not want to lend to each other in this climate, which means many have to turn to the ECB”.

Lower for Longer
This has been the mantra of the US Federal Reserve for a long time now – its pledge to keep borrowing costs at ultra-low levels for as long as needed to ensure sustainable economic recovery. Last week the Fed’s chairman, Ben Bernanke, maintained this message, saying the Fed would keep interest rates “exceptionally low” for an “extended period”. His comments late in the week came as doubts grew about the strength of the global economy – the fiscal austerity measures being taken across Europe have raised concerns that they could trigger a return to recession for some economies and weigh down recovery elsewhere. Japan became the latest country to commit to getting its public finances back in order by 2020, but financial markets were largely unmoved as economists doubted Tokyo’s ability to deliver fiscal sustainability. But the more downbeat mood in the Federal Reserve’s assessment of current conditions did chime with evidence of the dire state of the American housing market and a further downward revision to first-quarter US gross domestic product growth.

Figures released on Tuesday showed that sales of new US homes fell by a record 32.7% in May to the lowest level since figures started back in 1963. However, economists pointed out that sales are still up from a year ago and that the end of the first-time buyer tax credit was bound to have an effect. Sales of previously-owned homes also slipped back too, contrary to expectations, but on a brighter note the overhang of unsold properties declined by 3.4%. On the growth front, the downward revision of America’s first quarter GDP rekindled fears that the US economic recovery is running out of steam, following data showing consumer consumption – which accounts for around 70% of GDP – weaker than previously thought. However, economists at Barclays Capital said that “Corporate profit growth was revised higher and this should support consumer and business spending, consistent with our view that the recovery will continue to build momentum”.

Sugar Rush Dissolves
So by the end of the week, initial investor optimism had given way to a greater degree of caution with most markets reversing earlier gains to end the week lower. London was one of the worst performers, weighed down additionally by BP’s woes, ending the week down almost 4% as investor risk-appetite diminished. It was a similar story across European bourses and on Wall Street, although the latter saw a strong rally in banking shares late Friday when it became clear that US Congress plans to overhaul financial regulation were not as draconian as originally feared. Banks will still be allowed to own hedge funds, private equity funds and invest up to 3% of core capital in these vehicles. On the currency front, sterling enjoyed a good week gaining ground against both the euro (closing at €1.22) and the US dollar where it finished at $1.50. Earlier in the week, the pound received a fillip when it emerged that a member of the Bank of England’s Monetary Policy Committee had voted for a rise in interest rates for the first time in two years. Andrew Sentance voiced fears over rising inflation and wanted rates increased by 0.25% but was outvoted 7-1. The one place the renminbi sugar-rush did continue was, perhaps unsurprisingly, in Shanghai where the Composite index rallied over 1% on the week.

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