It seems likely that the UK economy is entering a period of low growth combined with rising inflation

In this week’s Bulletin:

  • Here in the UK it seems increasingly likely to some economists that the economy is entering a period of low growth combined with rising inflation.
  • Governor of the Bank of England, Mervyn King, said in a speech that the outlook remained very difficult following the MPC’s downward revision for growth and raised expectations for inflation.
  • China’s economy may be slowing with fewer imports and increased exports according to data out last week. This resulted in a record trade surplus. Economists say lower demand may see further falls for commodity prices.
  • Greece was angered when rating agency Standard & Poor’s downgraded its debt further into junk territory – it also increased the likelihood of a further bail-out by eurozone members for its sickly partner.
  • Overall, markets recovered from their mid-week wobble, ending mostly little changed on the week.
  • The Sunday Times reminded its readers how, even in these taxing times, it was possible to generate substantial income flows from investments yet only suffer basic rates of tax through a prudent mix of tax wrappers.

Stagflation Ahead?

Despite sunnier weather and a royal wedding it seems that the UK economy is still struggling – much to the frustration of policymakers who had hoped that UK plc would be in better shape following one of the deepest recessions for a generation or more. Data released last week showed that British industrial output may be growing but it is much slower than expected, with production growing by 0.7% for the year to March; the weakest performance since early 2010, according to the Office for National Statistics (ONS). The Times commented that the figures were disappointing given the tailwind manufacturers have enjoyed since the 25% devaluation in the pound, although a revival for manufacturing has seen it grow its overall share of the UK economy. The ONS said that, following six quarters of growth, manufacturing now accounts for around 11.5% of GDP. Economists searched for reasons of course, blaming subdued activity in the North Sea but also a feeble consumer. Supermarket giant J Sainsbury played down the impact of good weather and a wedding saying Britons were still worried about losing their jobs.

The situation was compounded following news that eurozone economic activity has enjoyed a strong revival, with activity beating expectations. GDP for the first quarter came in at 0.8%: twice the rate in the US and ahead of the UK’s 0.5%. But the numbers were skewed by a huge growth spurt for the region’s two powerhouses: France and Germany, who seem to be doing most of the work. Germany’s economy grew by 1.5% while France announced a 1% expansion in GDP – even Greece managed to grow by 0.8%, albeit from a low point after a year of declining activity. Unsurprisingly Germany’s economics minister claimed that “Germany is the growth motor among the industrial nations – and not just in Europe”. But as The Financial Times noted, the combined data masks the region’s north-south divide with growth in Spain and Italy staying sluggish. Either way, the numbers made for uncomfortable reading for policymakers, including the Governor of the Bank of England (BoE), Mervyn King.

Last week Mr King, speaking at a news conference, spent much of his presentation highlighting the difficult time Britain faces. The BoE has been forced to revise down its growth forecasts from 3.1% to 2.75% and many believe these are still too optimistic. The Governor said that “weakness in demand and output has reflected lower activity” and that the economy had been pretty “flat” over the last two quarters, concluding that, in the medium term, the “big picture is broadly the same”. Alongside lower growth, the BoE’s Monetary Policy Committee (MPC), in its May 2011 Inflation Report, also raised its expectations for inflation to 5%; way above the Bank’s 2% target. Against this uninspiring backdrop, the Governor also signalled that there is likely to be an interest rate rise this year but, in keeping with tradition, refused to predict when. The markets have been pricing in a small increase for some while now so his comments came as no surprise, just leaving analysts mulling over the likely timing. “Clearly the MPC is not trying to send a definitive signal of an intention to hike in August, but that appears to be its current approximation,” was the view of Nomura.

China’s Dilemma

Now officially the world’s second largest economy, China’s ascendency has been remarkable in many ways, but it remains fraught with difficulty for its government as it tries to rebalance its growth away from exports to greater organic, domestic expansion. The country’s huge need for raw materials has, inter alia, contributed to sharp rises in a host of commodity prices and, as we know, led to higher inflation in the developing economies. For some months now the authorities have endeavoured to curb bank lending by raising the cost of borrowing and also to slow a property boom that, along with higher commodity costs, was causing social friction. But all is not going according to plan. Last week, figures confirmed that China’s trade surplus ballooned back to its imposing ‘business as usual’ stature last month, smashing consensus estimates as exports soared to record levels of $11.4bn. With exports up and imports down, some analysts saw this as a cooling of the economy as the country brought in fewer goods for reprocessing.

Some warned of potentially troubling signals for the global economy if demand continues to fall, whilst sluggish import growth may also herald further corrections in commodity prices as government tightening policies begin to bite and the appetite of the world’s largest consumer of copper, coal and iron ore fades. This uncertainty led to a repeat of the previous week’s sharp commodity price falls with copper, gold and silver all falling mid-week. Oil prices fell sharply too, although this was probably more to do with news that there had been an unexpected build-up of US gasoline inventories – both Brent crude and WTI (the US benchmark) fell $5 per barrel. But the trade surplus news couldn’t have come at a worse time for China – it was having high level talks with the US last week on the unrelentingly contentious issues of trade and currency policy which have made for tense relations between the two countries.

EU Bailouts Balloon

Europe’s sovereign debt crisis rumbled on last week as it became increasingly clear to investors that the probability of further help for a beleaguered Greece grew ever likely. The situation was not helped when rating agency Standard & Poor’s cut Greece’s credit rating further into junk status from B to BB- saying “there is increased risk that Greece will take steps to restructure” its €110bn bailout package which would result in a “distressed exchange” for bondholders. To the markets that meant that bondholders were likely to take a haircut of 50% or more; so, predictably, bond markets lurched downwards, taking European equities with them. The need for a solution is an obvious imperative and the troika of the EC, ECB and IMF are reported to be working frantically behind the scenes to put together what The Sunday Times described as a ‘back-door bailout’ for Greece, to prevent the country defaulting and potentially throwing the bond markets into a hiatus.

As The Sunday Telegraph explained, the sovereign debt crisis threatening Greece has a clear cause and a clear solution. Too much money was lent (mostly by French and German banks) against assets that could not support that debt – the asset being the long-run growth potential of the Greek economy. The solution is to write off a large part of the debt in return for bringing the government deficit to zero, with lenders losing some of their money while the borrowers suffer a recession. Traditional IMF medicine usually combines fiscal tightening (which is underway) with debt restructuring and currency depreciation. Unfortunately for Greece, as a member of the eurozone, the latter two are not an option, which means a deep recession. In the meantime, the EU is trying to buy time via another bailout in an effort to restore good order – for foreign banks this is giving them the opportunity to offload as much of their Greek debt as possible, mainly to the ECB.

With Greece angered by the latest moves, the market has, once more, moved on, according to The Financial Times, and has now pushed Spain back into the limelight. After the rescue of Greece, Ireland and Portugal, investors are weighing up the probability of Spain heading the same way. The country has a gross external debt burden of €1,744bn, far exceeding that of the other eurozone bailout beneficiaries, although many remain sceptical as the country is successfully cutting its budget deficit. Foreign funds are giving the country the benefit of the doubt, it seems. “The debate has moved from ‘Will they need a bailout?’ to ‘Will there be any growth and is this a good place to invest my money?’”, was the view of one hedge fund manager. In the meantime though, the markets continue to keep a close eye on events.

Markets Drift

The strong GDP numbers from the eurozone certainly helped give sentiment a boost, partially offsetting concerns over China, although events in the world’s number one economy remain disconcerting for economists. According to new research from America’s major property website Zillow, US house prices have suffered their largest quarterly fall since the collapse of Lehman Brothers, underlining the scale of the headwinds still facing the world’s largest economy. Excess supply has apparently left repossessed homes accounting for around 40% of sales, which is driving prices lower – according to the S&P/Case-Shiller index, US home prices have, on average, fallen 33% from their July 2006 peak. Here in the UK the numbers are fortunately nowhere near so bad, although last week the Halifax said that house prices dropped by 1.4% between March and April. “Weak confidence among households, partly due to uncertainty over the economic outlook, is constraining housing demand and resulting in some downward movement in prices,” said their housing economist Mark Ellis.

So, by the end of the week, global financial markets had endured mixed fortunes. Commodities were down mid-week as said, but gold and silver managed to rally following strong buying demand from India and ended the week higher. Oil remained little changed, with Brent crude staying stubbornly high at $114 per barrel. In the equity markets, overall activity was muted with mid-week wobbles caused by Greece and China largely erased by close of business on Friday. Wall Street was marginally down; whilst, in the City, London share prices gave some ground with the FTSE 100 Index closing at 5,925.

Income Boost

An increasing number of investors are being pulled into higher rates of tax – particularly through changing tax bands – and this in turn is impacting significantly on net returns. However, with some good tax planning it is possible to receive high income streams yet only suffer basic rate tax. The Sunday Times illustrated how the canny use of pensions, investment bonds, Individual Savings Accounts (ISAs) and Capital Gains Tax allowances can reduce tax, citing an example of an investor who was able to generate almost £77,000 income but only pay tax at a rate of 20%. Combining pension drawdown, using the annual exempt CGT amount of £10,600, taking tax-deferred income from an investment bond and non-taxable income from an ISA means many investors could potentially boost their incomes yet remain as basic rate taxpayers. The key, as ever, is to take professional financial advice.

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