Chancellor Gordon Brown has boasted until blue in the face that the days of boom and bust are behind us. His speeches about the UK economy are peppered with words like “prudence”, “stability” and “investment”. But as with most things New Labour, there is more rhetoric than substance. The 13-year ‘golden age’, for which the Chancellor claims retrospective credit, is now over.
Stability has had its day and volatility is back. Now it’s time to get gloomy about the British Economy, and take some serious financial precautions.
Even the Bank of England cries a warning
This gloomy prediction is shared by the Governor of the Bank of England. In autumn last year, Mervyn King delivered a cautionary speech at the Eden Project in which he described the period since late 1992 as a Non- Inflationary Consistently Expansionary period or ‘NICE’.
The ‘NICE’ was a benign era when inflation was much less sensitive to economic booms than in the inflation prone 1970’s. Over the ‘nice’ period unemployment fell from nearly 9% to below 3%, while inflation was broadly constant and under control. King declared that this happy combination of low, stable inflation and continually falling unemployment must come to an end at some point. A year on, we’ve reached that point.
In a speech at the CBI North East annual dinner last week, the Governor said that the business cycle has not been abolished. He added that it seemed rather unlikely that the next 10 years will be as ‘nice’ as the past 10.
One of the main reasons is that we are now experiencing Don’t fall for M&S’s recent strength 23 OCTOBER 22 22000054 FIVE the flip side of the globalisation process that has integrated China, India and other emerging economies into the world trading system. The arrival of these low cost producers has lowered the price of our manufactured imports. This in turn has boosted our purchasing power at home. But now the rapid growth of emerging Asian economies is pushing up the prices of commodities like copper, aluminium, iron ore, and – most importantly – oil.
The illusion of ‘steady growth’
Cheap manufactured imports and higher petrol prices are both the products of globalisation. We have benefited from the former and now we are experiencing the latter. As a result the consumer has less at its disposal, the economy has slowed and inflation has picked up. Indeed, were it not for cut-throat competition between beleaguered retailers, inflation would be higher than the 2.5% recorded this week.
The Governor concluded: “there has grown up in recent years a false sense of our ability to maintain a smooth and steady growth rate of output.” The Chancellor is largely responsible for this misconception and for eight years he’s enjoyed his fair share of luck. But now that luck is turning.
Mr Brown blames higher oil prices for the fact that his growth forecasts for this year will turn out to be wildly overoptimistic. Growth this year is likely to turn out as low as 1.5% compared with the 3% to 3.5% originally forecast. But it’s funny how he didn’t credit low oil prices in the late 1990’s as a contributor to our incredible growth!
Favourable tailwinds are turning into difficult headwinds, and some are of his own making. Because higher energy prices are just one of many headaches facing the Chancellor.
Old Europe threatens to crush enterprise
Britain’s economic fortunes are inextricably linked with developments in the world economy. Until now, Gordon Brown has been fortunate that the US, by far the world’s largest economy, has delivered brisk economic growth, while China has added stimulus of its own. This has helped the UK grow despite virtual stagnation in our European export markets, the original six members of the Common Market delivering particularly feeble growth.
Meanwhile, the message from the recent German elections and this summer’s referendum in France is that people of ‘Old Europe’ are unwilling to embrace the economic reforms proposed by the political elites. Old Europe could quickly become a backwater where cushy public sector jobs are preserved at the expense of economic dynamism, where issues of equality take precedence over incentives, and where high public spending makes a low tax regime impossible.
With much of Europe in the vortex of political paralysis, economic decline and global irrelevance, can the US still be relied upon to keep the world economy from treading water? The omens for the next couple of years are not good.
US interest rates have been hiked 11 times since June 2004. With more increases in the pipeline, it’s conceivable that shortterm rates in the US could be higher than long-term interest rates. In technical jargon this unusual state of affairs is known as an ‘inverted yield curve’. The last two times we’ve seen this curve were in 1989 and in 2000. On both occasions they foreshadowed future economic weakness.
The US interest rate hikes will start to exert their maximum effect on the US and the global economy in the second half of next year. In short, Mr Brown cannot rely on exports to take up the baton from the consumer in leading economic growth.
Tax increases are now a near certainty
A shrewd Chancellor who had planned for these problems would have the scope to stimulate domestic demand. But Brown’s reckless decision to let public spending rip since 2001 has closed off this particular avenue. If he’d not been so extravagant with the taxpayers money, the 2006 Budget would have been an ideal time to shore up consumer confidence with tax cuts.
In reality, public borrowing will increase at alarming rates as faltering growth delivers disappointing revenues for the Treasury. So tax increases are now a near certainty.
Nor can the Chancellor rely on help from the Bank of England to turn on the monetary taps with interest rate cuts. The Bank of England is rightfully hesitant. Inflation is above target, money supply growth is running at double digits and this is fuelling a selective boom in asset prices. Reckless monetary easing would worsen this. The Bank is also concerned by the arrogance of a Chancellor who has moved the goalposts to satisfy his ‘fiscal rules’ rather than do something material about addressing Britain’s yawning public deficits.
The Chancellor is boxed in by spending plans
Worst of all, the Chancellor is sticking doggedly to overambitious public spending plans. This means higher public borrowing, or higher taxation, or a combination of both. The OECD and other independent analysts reckon about £13bn of tax rises would be needed to keep fiscal policy on track.
This will of course do nothing for consumer confidence, growth prospects or the UK as an attractive place to invest in. Any consequent fall in the pound on the foreign exchanges will make the Bank of England even more hesitant about cutting rates.
Unless Gordon Brown has a rethink about the scope of the welfare state, the man has nowhere to turn. When he delivers his pre-Budget statement next month he has two options. Either he will produce a litany of carefully selected statistics designed to justify his position or he can come clean and demonstrate how he is going to attend to the challenges ahead. I’m not optimistic.
So where does the end of our ‘Golden Age’ leave your investments?
The recognition that the UK economy is about to enter choppy waters has been reflected in the cautious tone of the stock market this month. Having traded above the 5,500 mark on the first trading day of October, the FTSE 100 index is now over 6% lower.
More worrying is that most shares listed on the FTSE 100 are down this month. One of the worst casualties being PartyGaming, a stock we urged you to avoid. Indeed, on page 4 we have highlighted another high profile stock that you should give a wide berth.
At the same time, US Treasury bonds have fallen sharply over the last month on inflation fears on the other side of the Atlantic. We have often said that when US long-term interest rates harden it will make life difficult for our stock market. So we expect stock market weakness to persist in the short-term and hence we have elected to close out some equity list selections, as you’ll see.
On the other hand, it’s not yet time to head for the hills, because the FTSE 100 index is better value in price-earnings terms than it was at the beginning of last year, when the market was hovering around the 4,500 mark. Back then the index traded on a price/earnings multiple of over 18, now this measure is below 14. On this basis the stock market is not particularly stretched.
Brian Durrant is the Investment Director of The Fleet Street Letter.
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