Spend Spend, Spend

Posted on: 02 December 2008 by Gareth Hargreaves

Financial expert Graham Kerner picks out some of the key financial and economic issues touched on in the press this week.


Spend, spend, spend - this was the Chancellor’s solution to the UK’s economic woes apparently, as he announced large increases in government borrowing plans to fund central spending over the coming months. Some of that borrowing will fund the tax breaks for individuals he announced in his pre-Budget Report last Monday.

Edward Bonham Carter, Chief Executive of Jupiter Asset Management, gave his views on Alistair Darling’s plans. “The extent to which the credit crunch has impacted on the wider economy has become clearer following Chancellor Alistair Darling’s Pre-Budget report. The Chancellor is forecasting GDP growth of just 0.75% for 2008 and then a contraction of between 0.75% and 1.25% for the UK economy during 2009.”

“The Chancellor then forecasts that the economy will bounce back with positive growth of 1.5% to 2% in 2010. Given the overhang of debt the UK consumer has to clear and the continued contraction in bank lending to consumers and corporates, such a sharp recovery seems optimistic.”

“This is without doubt a severe economic contraction and one that requires a significant policy response. The Chancellor’s confirmation that VAT will be cut from 17.5% to 15% until the end of 2009 will put an estimated £12.9bn in consumers’ pockets – a move he hopes will be enough, together with interest rate cuts, to encourage consumers to spend their way out of trouble.”

“Will his efforts be enough to spur a recovery or will consumers continue to hoard cash? Much depends on whether consumers view the 250 basis point cut in VAT in the same vein as they would an income tax cut and as a real additional benefit when they are already being offered significant discounts of 20% or so in retail sales.”

“While it may be true that without this fiscal loosening, the recession could be longer and deeper than the Chancellor currently forecasts, the cost will place an enormous burden on the UK economy for many years to come.”

“The increased borrowing will be partially financed by a sharp rise in gilt issuance – some £36bn of government bonds are to be issued between now and the end of the fiscal year in April 2009. This is in addition to the gilts issued to bail out the UK banking system in October and is more than many market participants expected.”

“However overall, investors are right to take heart from the government’s measures as, together with the 1.5% cut in base rates earlier last month; they give further confirmation that policymakers are prepared to do whatever is necessary to limit the impact of the credit crunch on the wider economy.”

“I would expect further loosening – probably in monetary policy – to take place over the coming months. Investors also need to consider the impact lower interest rates will have on their deposit savings.”

“Savers in the UK now have some £1 trillion on deposit and a 1.5% cut in saving rates will reduce their interest payments by up to £15 billion. They will, as a result, be increasingly keen to find sources of safe and reliable income.”

“It is worth remembering that over time, the majority of investors' total returns from equities come from dividend growth and the reinvestment of those dividends and so income funds investing in the UK or other markets are likely to prove an increasingly attractive option.”

Everyone’s A Winner

So in terms of strategy, the hope is that UK consumers will spend the extra money to help the economy avoid a deep and prolonged recession.

The immediate outlook is none-too promising though – The Financial Times reported data that showed consumers tightened their belts in the third quarter of this year: spending fell 0.2%, which although seemingly small, is the largest drop since late 1995. So who will benefit from the big tax giveaway?

The Times explained that millions of people will have extra disposable income, but pointed out that the Chancellor’s generosity will be temporary, with big tax rises planned for the better-paid in 2010 and 2011 and a 0.5% increase in National Insurance affecting millions of workers and employers alike.

The issue of funding government spending via gilt issuance was picked up by The Times which said the Debt Management Office will have to sell £146bn of gilts before the end of the financial year.

Apart from plugging the gap as a result of falling tax receipts, some of the money will fund the cost of recapitalising some of the UK’s leading banks plus the cost of bailing-out savers caught up in the collapse of the Icelandic banks.

The Sunday Telegraph’s assessment was somewhat caustic, describing Gordon Brown’s borrowing binge as dangerous bravado, supporting its case by illustrating data provided by the Institute of Economic affairs.

It seems that if liabilities relating to public sector pensions and the private finance initiative are added to public-sector debt, the UK’s national debt is 276% of GDP – putting the UK in third position behind Japan and the US.

Banks Under Pressure

Apart from encouraging consumers to spend, the other part of the problem is to get the banks lending again and ministers have been making hawkish noises as to what might happen if they don’t. The Governor of the Bank of England went so far as to hint at the possible nationalisation of the major banks as a final option.

The Financial Times illustrated the problem of lenders’ recalcitrance – mortgage approvals last month fell more than a half from a year earlier according to the British Banker’s Association. Analysts are of the view that rising unemployment and tighter lending criteria will offset any stimulus from lower interest rates.

So, unsurprisingly house prices fell once again last month, but for the first time the rate of decline has slowed although many experts believe it’s a blip and that prices will continue to fall into next year.

The problem of how to get the banks to lend more is obviously a tricky one – especially as the economic backdrop has deteriorated from last year and the risks of more borrowers defaulting are therefore increasing.

The Sunday Times explained that, on the one hand, the banks are being blamed for reckless lending in the past, but are now being told to lend into a falling economy. The paper went on to say that banks have been eager to demonstrate they have been increasing lending – Lloyds says it has lent 18% more year to date to the small business sector.

The banks argue that their recent re-capitalisation was meant to put them in a stronger position to meet new defaults because of recession: not to use the money to lend. But if they did decide to lend more how could they fund it?

Over the past decade the explosion of credit was funded by banks borrowing from the wholesale money markets – much like Northern Rock. The Times said everything from mortgages, credit card debts and loans to private equity were packaged up and sold to hedge funds and other large institutions.

These sources of credit soaked up half of all UK lending, but have now evaporated so the paper opined that no amount of government pressure on British banks will persuade these investors back into the market.

Hank’s Largesse

Meanwhile, over on Wall Street the markets were surprised when the US Federal Reserve threw an $800bn lifeline to America’s fractured credit markets in the latest sign that Washington has been stunned by the speed and severity of the US recession.

The new funds bring to $1.7 trillion the total taxpayer money used to bail out America, with another $500bn of tax cuts in the pipeline, according to The Financial Times. Outlining the measures, US Treasury Secretary Hank Paulson said that “We are dealing with a historic situation that happens once or twice in a 100 years”.

America’s latest state-aid fund – called the Term Asset-Backed Securities Loan Fund or TALF– has been designed to make it easier for consumers to obtain car, credit card and student loans.

The measure means that banks can secure new capital but do not have to sell and take a subsequent loss on bust bonds as the Fed is offering to lend funds instead, taking these untradeable bonds as collateral.

The Fed’s action pushed mortgage rates sharply lower and as a corollary caused the yield on 10-year US Treasury debt to fall below 3% for the first time in 50 years. The Fed’s actions are likely to trigger a wave of mortgage re-financing which should take some of the pressure off consumers who are currently in complete disarray.

Data released last week showed collapses in new home sales, consumer spending and orders for durable goods, re-inforcing the gloomy economic outlook and highlighting the need for action by the authorities.

But the poor economic news wasn’t confined to the US – in Japan industrial production and household spending fell more than expected in October, raising the spectre of a prolonged recession and a possible reversal back into deflation.

In China, interest rates were cut by over 1% - the largest in a decade – as the central bank took aggressive steps to prevent a slump in the world’s fourth largest economy. And it seems that even in glitzy Dubai the property market has ground to a stunning halt with the state’s leading builders hit by the credit crisis, leading to the launch of a government backed mortgage company to attempt to revive the ailing market.

Markets Sparkle

But whilst the economic news may have been uninspiring, global financial markets enjoyed one of their best weeks for many months – in the case of London, the FTSE100 enjoyed its largest weekly rise ever registering a 13.4% gain.

It was a similar story elsewhere, with European bourses up by over 10% and large gains notched up on Wall Street and in Tokyo. One of the reasons stock markets advanced so strongly was down to the news that the US Treasury was set to rescue Citigroup – shares in the bank had fallen 60% the previous week leading to concerns about its viability.

Coupled with actions by policymakers this news was sufficient to give a big boost to confidence and encouraged investors back into the markets to buy up stocks at very depressed prices following weeks of battering.

Whilst it may be premature to call an end to the recent sell-off, traders are hopeful that it could signal the start of the traditional year-end rally.

Falling Rates

With another cut in UK interest rates a strong possibility, headline saving rates offered by banks and building societies are beginning to fall fast and, unsurprisingly, investors are seeking out alternative investment opportunities.

Whilst there is a need for everyone to hold some cash there are other choices too – especially if income is a priority. The Sunday Telegraph commented that the average savings rate is 1.94% and one in five accounts pay less than 1%. Gilts have been a haven this year and are up a few percent this year, but its corporate counterpart – corporate bonds – has been lacklustre: a point discussed by the paper.

These funds invest in debt issued by blue-chip companies and are recognised as being less risky than equities. However, in recent months many bonds have fallen by more than 10% which is unprecedented for assets that are supposed to offer a relatively safe halfway house between cash and equities.

The paper explained that the demise of Lehman Brothers had shaken the markets, leading to a rush for gilts, but today many corporate bond funds are yielding 10% or more.

The Telegraph concluded that if you think companies will ultimately recover, corporate bonds have got to be a better opportunity enabling investors to lock into high yields and enjoy potential capital growth when the economy picks up again.

1st December

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