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FT Investment Advisor

Focus: Safe on solid ground?

08.02.10
 
It's official: the UK has finally clawed its way out of recession - but only just, and it is the last major global economy to do so. Advertising The Bank of England (BoE) announced last month GDP had increased by 0.1 per cent in three months to the end of 2009 after six consecutive quarters of contraction, which saw the economy shrink by 6.1 percentage points 4.8 per cent in 2009 alone.

If this figure is accurate, it falls short of economists' predictions of 0.4 per cent growth in Q4 2009 and the BoE's own optimistic 0.6 per cent. By comparison, France and Germany both showed growth of 0.3 per cent in their first quarter of recovery more than six months ago.

This tiny expansion is despite - or perhaps because of - the overnment's car scrappage scheme and a consumer rush to beat VAT's return to 17.5 per cent after a 12-month temporary drop to 15 per cent. Without such measures there is the real risk of dropping back into the red this quarter, economists say, and even chancellor Alistair Darling has admitted the road to recovery will be 'bumpy'. Even ignoring the volatile output
from oil and gas extraction, growth was only 0.2 per cent in Q4 after a flat Q3 2009. Additionally, the (barely) positive Q4 figures are the Office for National Statistics' preliminary results based on just 40 per cent of relevant data. Data reviews expected on February 26 and March 30 could still go either way.

So what happens next? The London Chamber of Commerce and Industry has reported that more than 30 per cent of businesses now expect the economy to weaken this year, up from 20 per cent three months ago. The survey echoes many commentators' predictions of anaemic growth and the real risk of a double-dip recession, particularly given the unsettling effect of a looming general election and the Bank of England's recent decision to pause quantitative easing (QE). 'The news suggests [recovery] is likely to be even more of an uphill struggle than had previously been supposed,' Ted Scott, director of UK equity strategy for F&C Investments, says. 'It means the UK economy will probably grow at well below trend - at about 2.5-3 per cent GDP per annum for the
foreseeable future.

The consensus forecast for 2010 is about 2 per cent, and this now looks too high in the light of the disappointing data for both the third and fourth quarters of last year.' The GDP announcement saw sterling plummet by 1.3 cents against the US dollar to $1.61 and by 0.45 cents against the euro to 1.14 after stronger growth priced into the market failed to materialise.

Along with the risk of an indecisive election, the greatest effect on sterling's performance in the short to mid-term is whether the BoE is spurred by the latest GDP figures into halting QE, which many believe it will. 'There can be little doubt that emerging from recession has come as a psychological boost to the UK economy, and has consequently given the pound some support,' says Duncan
Higgins, a senior analyst for Caxton FX. 'Currently, sterling has moved to a five-month high against the euro, just marginally below 1.16. There were strong inflation figures of 2.9 per cent in December, and if the Bank decides to conclude the asset purchase scheme, the pound should find further upward momentum, possibly moving to 1.17.'

Meanwhile, such slight growth saw the FTSE 100 drop by almost 30 points to 5,276.85 its fifth consecutive day of decline, from a 52-week high of 5445.20. Bad news for domestic stocks relying on UK consumers - but with two-thirds of blue chips deriving principal income from overseas, UK equities need not be written off.

Aruna Karunathilake, manager of the Fidelity UK Aggressive fund, says: 'Indicators of economic activity, such as the OECD Composite Leading Indicator, the Consensus 12-month EPS (earnings per share) and yield curves increasing in the UK, continued to improve through last quarter.

Commentary from companies also indicates we are seeing signs of improvement in the real economy,' he says. 'Low interest rates and loose monetary policy provide a positive backdrop for all asset markets.' He does, however, admit the phased withdrawal of monetary stimulus poses a significant risk to the recovery in asset markets and the real economy, and says he is concernedabout the UK spending outlook considering likely higher taxation and unemployment levels. 'I have cut back on
holdings in UK consumer-facing stocks [in favour of those] which operate in markets with a stronger consumer outlook,' he adds. In fact, last week saw a retail investor buying spree with a 61 per cent increase in overall top-10 trades, including Barclays, Xstrata and Rio Tinto, according to TD Waterhouse.

As for consumers, interest rates are expected to remain low, with peaks of 3-4 per cent rather than the 5-6 per cent seen in previous economic cycles, because of the QE policy. The swap rate market shifted swiftly following the release of the GDP figures, and now price interest rates at 3 per cent in five years, down from 3.25 per cent previously. 'This is bad news for much-maligned savers,' says Philip Booth, editorial director for thinktank the Institute for Economic Affairs. 'But printing money keeps interest rates low. That keeps borrowing stable, money in consumers' pockets and spending up. It's good for retailers, but I'm not sure we should be encouraging consumers to keep spending.' Peter Hensman, global strategist for Newton Investment Management, warns that
while the BoE's aggressive interest rate cuts eased homeowners' mortgage repayment burden, and fiscal stimulus has underpinned spending in the near term, these measures leave unaddressed the UK's longer-term challenges.

'The uncertain political backdrop is likely to have increased household and business caution,' he adds. 'However, unemployment may not prove to be as great a challenge as anticipated. Greater wage flexibility, and a more rapid interest rate response to the peak in house prices that occurred in the early 1990's, could contribute to a better employment outlook than many have forecast.' But with Mr Darling last month committing to halve Britain's 178bn budget deficit within four years, accountants Smith & Williamson predicts a VAT increase to 20 per cent, a further 0.5p in the pound on National Insurance, and a 1 and 3 percentage point increase in basic and higher-rate tax bands, respectively. A 50,000 salary could carry a tax liability of 18,673 in 2011-12, its research showed.

'From a macro viewpoint, [the figures] will make it more difficult for the government to address the pressing issue of the large deficit, with the amount of debt on its books relative to GDP at a record high for peace time,' Mr Scott says. 'The GDP figures highlight the urgency of a cogent and workable plan that will reduce our public borrowings, while at the same time restoring the economy to an accelerating growth path. If this is not done, the UK's sovereign debt could come under the spotlight,' he warns.

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