Market Watch From Redmayne Bentley - Leeds Financial

 As last week began the pound fell and approached its lowest level against the dollar in the month, this followed reports showing that the UK housing recovery is flagging and Fitch the credit agency said Britain needs to accelerate budget cuts.  Brian Coulton the agency’s head of sovereign ratings said the UK has seen “the most rapid rise in the ratio of public debt to GDP of any AAA rated country” and is courting fate with its leisurely plan to half the deficit by the middle of the decade.  “It is frankly too slow a pedestrian pace.  Why the UK thinks it has more time than other countries we are not sure.  This needs to be reoriented” he told an audience that had been assembled to hear Fitch’s views on sovereign debt issues around the world.  Later in the week the Prime Minister had a chance to convince the markets that he can half the UK budget deficit if he wins the election and disappointingly he failed to address bond market concerns, which remain in a highly nervous state.  They want reassuring about the UK and unfortunately the Prime Minister presented them with his familiar mixture of vague objectives and wishful thinking.  Whilst Gordon Brown continues to talk about the new legislation which obliges the Government to half the budget deficit in five years these investors know that any future Government is unlikely to fine itself for breaking its own law and certainly not the present administration who have redefined their terminology of the business cycle to the point of ridicule, following its failure to meet earlier core pledges.  No more boom and bust is also ringing loudly in their eyes. The same investors are concerned that either Mr Brown does not know how to half the deficit or that he knows that the cuts will be so painful that the electric cannot be told.  To avoid breaking his new rule the deficit must be cut by about £90bn, the combined budget for education and defence or roughly the entire health budget.  Whilst the audience would not have expected him to overshadow the March 24th budget, expectation of something more substantial than electioneering and an indication that Mr Brown grasps the enormity of the tasks ahead or an explanation of why national debt more than 100pc of GDP is manageable would have at least helped smooth the situation over.  Sterling is increasingly becoming the focal target for international investors to abandon and speculators to push lower.  For a man who claims his greatest policy error in 13 years for the UK economy was a failure to ensure better cross border coordination, one perhaps could not have expected anything more.  Confirmation that the budget will be on the 24th March, all but confirms that Election Day will be the 6th May - as we have thought for quite some time.  UK public inflation expectations for the year ahead edged up in February whilst satisfaction with the way the Bank of England is doing its job rose to its highest level since May 2007.  The quarterly survey released by the Bank of England on Thursday found that UK consumers expect prices to rise 2.5pc over the next twelve months compared with 2.4pc in November.  There was also a rise in perceptions of growing inflation with respondents seeing it at 3.4pc up from 3.2pc in November.  This may also suggest that public inflation expectations remain well anchored despite a jump in annual inflation over the past couple of months to 3.5pc in January from 2.9pc in December and just 1.9pc in November. The UK trade figures for January were dreadful and worrying because sterling’s fall has not given British exporter volumes the boost that would have been expected.  It would appear that cautious manufactures have elected to rebuild margins and balance sheets rather than chase new business and utilise the large amount of unused spare capacity that the Bank of England continues to highlight.  Worryingly if you look further into the numbers the gloom grows as it shows that January’s weather damaged our exports yet it failed to stop imports coming in.  Our trade deficit with the rest of the world reached its widest since August 2008 in January as it unexpectedly jumped to £3.8bn in January, compared to £2.6bn the month before.  With sterling around 25pc weaker than it was before the credit crunch exports of goods fell in January by £1.4bn or 7pc, the worst monthly decline in exports since July 2006.  Imports also fell but less sharply reducing the deficit by £1bn to £8bn.  Britain’s manufacturers also suffered their biggest fall in production in six months at the start of the year, which saw factory output falling by 0.9pc in January.  This shocked investors as they had been expecting an increase of 0.3pc in January.  This was the biggest monthly drop since last August and reversed December’s strong 0.9pc increase.  On a more positive front retail sales bounced back in February after a tough January on the high street, figures from the British Retail Consortium showed.  Like for like sales were up 2.2pc compared with the 0.7pc fall seen in January when snow was blamed for the decline. According to Price Waterhouse Coopers an extra £20bn of tax rises or spending cuts will be needed by 2013-14 to build Britain’s budget deficit.  The firm said its predictions were based on less optimistic growth forecasts over the medium term compared with the Treasury’s, with them suggesting trend growth in the UK is likely to be 2.25pc a year and not the 2.75pc forecast by the Treasury.  It is estimated that Government borrowing would be around 5pc of gross domestic product in 2014-15 than the Treasury’s forecast of 4.4pc.  They suggested the gap could be eliminated through a number of possible combinations of tax rises and spending cuts starting from 2011-12 and building up to around £20bn a year by 2013-14.  During the week the British Chamber of Commerce cut its growth target for next year in its latest quarterly economic forecast.  It now expects the economy to grow by 2.1pc next year from only 2.3pc predicted in April forecasting growth this year of just 1pc.  It is also suggested that the Government must scrap the planned rise in National Insurance, freeze public sector wages and address public sector pensions if they are serious about tackling the deficit. The latest survey of house prices from the Royal Institute of Chartered Surveyors reported price weakness and I fear that this that is a sign of things to come.  They reported that people are holding off agreeing deals on property in anticipation of the general election with concerns about budget cuts and potential tax rises.  A total of 17pc more estate agents reported a rise than a fall in house prices last month down from 31pc in January.  Whilst there is significant latent demand the lack of funding remains a problem and particularly for first time buyers.  They suggested this is unlikely to ease in the near term as traditional mortgage lenders look to reduce their balance sheets in the wake of the unavailability of wholesale market funding which at the height of the market saw the issuance of mortgage backed securities worth £110bn between 2006 and 1007. Turnover in the housing market fell sharply in January, increasing my belief that prices will be heading lower. The Council of Mortgage Lenders said that the number of loans to buy houses in January was only 32,000 approvals, half of that in December 2009. The drop was blamed on a combination of snow and the end of a stamp duty holiday for lower-priced homes. Figures show the number of mortgages approved fell by half in January following the end of the stamp duty 'holiday' on homes worth between £125,000 and £175,000. Only 32,000 loans, worth £4.7billion, were advanced during the month in a 49 per cent fall on December, the Council of Mortgage Lenders said yesterday. The drop was even steeper among first time buyers, only 11,300 of whom secured a mortgage. That is a 54 per cent drop between December and January.  These funding problems saw authorities not only in the UK but in the US pump liquidity into the system at the height of the credit crisis.  The US Federal Reserve bought mortgage-backed securities and as a result, due to the degree of assistance the Fed provided it is currently holding about $1,200bn of Mortgage Backed Securities, which is about half of its (currently enormously expanded) balance sheet and is about a quarter of the total stock of high quality outstanding MBS) and The Bank of England came up with two special funding schemes both of which it intends to end by 2014.  The Council for Mortgage Lenders suggests that this will leave a hole of £300bn, which will need to be funded.  This lack of funds points to lower house prices as does the ratio of price to earnings which need to fall by around 20% in order to return to its long term average.  I believe this important gauge is likely to fall below its long-term trend line before we have seen the housing market fully stabilised.  The UK’s fixation with property will ultimately be dented by this exercise and it may well refocus people’s attention on the fact that the economy is ultimately much more important to us than rising property prices. Only in Britain would it have been possible for a fall in output of almost 5pc in 2009, to be accompanied by a larger jump in house prices and for it to been seen as a cause for celebration.  Speaking in the week Kate Barker a member of the Bank of England’s rate-setting committee and who has played a significant role in steering monetary policy during the financial crisis confessed that she had seriously underestimated the risks of the crisis.  In her last speech before leaving the Committee Kate Barker said that given the extent of the slowdown she was unable to look back on her thirteen years as a policy maker with the degree of satisfaction that she would have wished.  She concluded that during the pre-crisis years modestly higher interest rates may have discouraged households and businesses from increasing their debt levels which has left the economy much more resilient when the crisis took hold.  The squeeze on public sector pay for at least more senior staff began on Wednesday when the Government announced a freeze from April for almost 120,000 high-ranking employees.  Top civil servants, NHS managers, judges, hospital consultants and family doctors along with the most senior military will be targeted.  The Government has announced a cap of 1pc on rises for all staff for the two years from April 2011.  George Osborne the Shadow Chancellor has said an incoming Conservative Government would freeze pay for about two thirds of all public sector workers from April next year with no increase for anyone earning more than £18,000. The experience of the early 1990’s suggests that the best mix of economic policy for the UK as it comes out of recession is for a tightening of fiscal policy so that monetary policy can remain loose.  Monetary policy is all about interest rates and the level of the pound whilst fiscal policy is concerned with taxation and public spending.  Although low interest rates and a weak pound help manufacturers by keeping the cost of new investment and capital cheaper, as we know over the past few years it also puts pressure on the cost of living though a higher cost of imports and encourages investment in speculative assets and investments.  It is this latter area that fiscal policy addresses. By rising taxes or cutting public spending it squeezes consumer demand and Government investment leaving room for a private sector led recovery driven by manufacturing and exports.  This is not just text book stuff, the economy was re-balanced in this way after we left the exchange rate mechanism in 1992 and I believe that this will be central policy to any new Government after the general election.  We can therefore be assured that taxes will rise and the period of austerity will continue for a good couple of years to come.

 

Whilst the UK banks would prefer to forget about their near death experience in 2008 the Financial Services Authority in the week, barely a year after the Regulator ordered larger lenders to prepare their balance sheets for a severe downturn, has again asked them to repeat the exercise and unlike last year when the stress tests assumed peak unemployment of 12.5pc and a peak to trough slump of 6.9pc in gross domestic product the FSA is now assuming that even a more severe downturn with GDP falling by 8.1pc from peak to trough and additional 2.3pc point drop with unemployment rising to 13.3pc.  Whilst the Doomsday scenario is unlikely it would appear that the watchdog is determined to make UK banks almost bomb proof.  Although global rules on asset reserves are forcing banks to put more to one side in good times may make the stress test unnecessary.  Analysts at Credit Suisse believe UK banks will have to reduce the size of their balance sheets by many hundreds of billions over the next three to four years to meet new regulations.  It believes that British banks need to raise between £420bn and £750bn of long term wholesale funds, which they believe is consistent with them having to contract their balance sheets by between 6 to 18pc to compensate.  They also predict a minimum reduction in credit of £200bn.  The UK banks are well known for having gorged themselves on cheap wholesale funding during the boom times, issuing an avalanche of mortgage and commercially backed property paper.  The collapse of the Northern Rock closed this market and whilst it is creaking open it will never return to its former days.  Credit Suisse believes the biggest problem lies with Lloyds Bank, which needs to raise £185bn to £350bn, and will have to shrink its assets by £110 to £230bn.  In the case of Lloyds and the Royal Bank of Scotland, Credit Suisse is assuming that balance sheets will need to be contracted by around 20pc, somewhat bigger than the management of the underlying banks are currently assuming.  This contraction of the balance sheets will continue to limit credit availability throughout the economy as the deleveraging process from the credit crunch plays out for many more years yet to come. The UK Government cancelled the coupons last June on two permanent interest bearing shares or PIBs in Bradford & Bingley and the independent valuer has now decided that these bond holders are not entitled to compensation, so the investors who bought some £105mn of these look likely to receive nothing, although PIB holders who are being represented by the Bradford & Bingley Shareholders Action Group are now considering launching a judicial review against the Treasury.  Under the terms of the Bank’s nationalisation in September 2008 bond holders will not get any money back until the Bradford & Bingley has fully repaid the £14bn owed to the financial services compensation scheme and £4bn owed to the Government with interest.

 

When one looks and hears about the FTSE 100 it is entirely wrong to assume that this is a measurement of the UK’s economic performance.  The UK index is an internationally diversified measurement where we have been told in recent weeks that Essar a large Indian conglomerate is considering raising £3bn from a listing of all its African oil assets. Barrick Gold currently co owned by Barrick Gold of Canada, is also looking to be floated on the London Stock Exchange.  Both these international companies will automatically receive a place in the index although their Head Office and operations are overseas.  Thanks to a boom in the business of index trackers, exchange traded funds and other derivatives every new entrant into the FTSE is assured of strong demand and tracking funds which try to replicate their portfolio with 80pc of the FTSE constituents, trying to get that performance from the other 20pc, will also be forced to take up stock.  The index has naturally evolved since 1984 and contains only 35 of its original constituents.  The growing internationalisation of investment with every big fund around the world wanting exposure beyond its home territory is also continuing to blur the distinction between different markets.  Currently it is easy to construct an emerging markets or a US dominated portfolio entirely from constituents within the FTSE 100.  The All Share Index, which has a wider representation of stocks, listed on the London Stock Exchange, also needs to be treat with some caution as the FTSE 100 represents 84pc of its value. The internet changed last week and whilst it will have gone unnoticed to all but the anorak brigade the implications and changing dynamics will have a very big impact over the medium term.  The reason for this is that Cisco who manufacturers most of the core internet backbone announced that is has successfully trialled a router that can handle 322 terabits of traffic a minute or enough to stream every movie ever made in four minutes.  Whilst the effect will not be an overnight upgrade to networks, who are only just being scaled up to handle 100 gigabytes per second or 3,200 times less than what Cisco is trumpeting - it clearly shows the capability and more importantly the opportunities that will be with us once these networks are able to handle the potential additional speed and whilst it will not be imminent a few years down the line I am sure 100 gigabytes per second will be deemed tirelessly slow by the internet surfers of the day.

 

I am always concerned when huge amounts of money by private investors are rushed into investment funds, as this normally indicates that the market is heading for a fall.  According to figures from the Investment Management Association, UK investors invested £1.81bn of new money in UK-based unit trusts and open-ended companies during the month of January the highest level for January since records began in 1959 and 55pc above the same month last year.  The figure was slightly down on the £2.2bn invested during December although the IMA attributes this to the traditionally seasonal dip, which has seen investment levels lower in January than in December for the past eight years. In the US Equity mutual funds are spending free cash at the fastest rate in 18 years, leaving them with the smallest reserves since 2007 in a sign that gains in markets may be ahead of events. Cash dropped to 3.6 percent of assets from 5.7 percent in January 2009, leaving managers with $172 billion in the quickest decrease since 1991, Investment Company Institute data shows. The last time fund managers held such a small proportion was September 2007, a month before the S&P 500 began a 57 percent drop, according to data compiled by Bloomberg.

On the April 15 decision the US Treasury department must make the decision as to whether to label China as a “currency manipulator” as political pressure continues to grow in the US for action against China if it does not abandon the peg to the US dollar that has held since mid-2008. Since July 2008, the peg has been set at 6.83 RMB per dollar. Back in Jan 2009, Tim Geithner, the current US Treasury Secretary, said: "President Obama believes that China is manipulating its currency." The tough talk has since been watered down, with the US and its Western allies consistently arguing that the dollar-peg keeps the Yuan "artificially low", making China's exports more competitive, to the detriment of Western goods. The US however needs to be very careful as the country is being kept afloat by China's willingness to keep buying US government debt and the US is now at risk of sparking what could be an all-out trade war would be terrible for the whole global economy. China had appeared to signal it was considering a shift in policy when the head of the central bank said last weekend that the currency peg was a “special” policy for the financial crisis and that it would be abandoned “sooner or later”. What the US says and how China responds will set the tone for global trade and foreign exchange markets for the rest of 2010, if not the next few years. Moves by either towards greater protectionism will be very badly received with retribution likely to be swift. The U.S. trade deficit unexpectedly narrowed in January as oil import volumes hit there lowest in more than a decade, the Commerce Department announced in the week. The U.S. deficit in international trade of goods and services decreased 6.6% to $37.29 billion from a revised $39.90 billion the month before. The December trade gap was originally reported as $40.18 billion. The January deficit was lower than Wall Street expectations of a $41.0 billion shortfall. US exports decreased by 0.3% to $142.66 billion, from a revised $143.15 billion the previous month. Imports slipped by 1.7% to $179.95 billion from $183.05 billion in December. The U.S. bill for crude oil imports in January fell to $18.12 billion from $20.28 billion the month before, despite a 69-cent rise in the average price per barrel to $73.89. Crude import volumes fell to 245.27 million barrels, the lowest level since February 1999, from 277.07 million the month before. The U.S. budget deficit was at a record in February as the government boosted spending to help revive the economy as it recorded a $221 billion last month, against a shortfall of $194 billion in February 2009. The figures show the deficit this year will probably be above the record $1.4 trillion in the fiscal year that ended in September. U.S. foreclosure filings rose at the slowest pace in four years in February as the government sought to reduce record bank seizures, Realtytrac Inc. said. A total of 308,524 properties received a notice of default, auction or seizure last month, or one in 418 households, the Irvine, California-based seller of default data said in a statement. Filings rose 6 percent from a year earlier, the smallest increase since Realtytrac began tracking annual changes in January 2006. The Obama administration’s main effort to keep people in their homes resulted in more than 830,000 trial loan modifications for delinquent borrowers through January, according to the Treasury Department. Although filings were up for the 50th straight month in February on an annual basis and topped 300,000 for the 12th consecutive month, Realtytrac said. The preliminary University of Michigan/Reuters consumer sentiment index moved to 72.5, from 73.6 in February from 74.4 in January. Economists had expected the preliminary index, which will be revised later in the month, to stand at 73.8. The Michigan report arrived on a day where the government reported retail sales during February unexpectedly rose, up 0.3% against an expected drop of 0.3%. Stripped of auto sales, retail sales rose by 0.8%, a solid showing. Worryingly though January retail sales were adjusted downward, to a 0.1% increase from a previously reported 0.5% gain.

In China Consumer prices rose by 2.7 per cent in February from a year ago, well above January’s 1.5 per cent increase and close to the 3 per cent ceiling that Premier Wen Jiabao set for this year in his speech to the National People’s Congress. Industrial production also accelerated, increasing by 20.7 per cent for the first two months of 2010 over the year before. The figure came in above analysts’ forecasts and the 18.5 per cent increase recorded in December. Factory gate prices climbed 5.4 per cent in February against 4.3 per cent the month before. The latest jumps in inflation and industrial output follow a bigger than expected increase in exports last month and will add to fears that the Chinese economy runs the risk of overheating as a result of the massive stimulus measures introduced last year. New bank loans reached Rmb700bn ($103bn) last month, down from the Rmb1,400bn in January but above forecasts. Because of the weeklong Chinese New Year holiday, which was in February this year and January the year before, Beijing released some of the figures on a two-month basis in order to reduce distortions. Retail sales grew in line with forecasts, rising 17.9 per cent year-on-year in January and February, up from 15.8 per cent in December, while fixed asset investment surged 26.6 per cent in the first two months of the year, from 20.5 per cent in December. The authorities have already taken some mild measures to tighten monetary policy, raising bank reserve requirements twice since the start of the year. They will now be under pressure to take bolder steps.

 

Japan's economy grew by less than first estimated in the final quarter of 2009, revised figures showed last week. The Cabinet Office said the economy expanded by 0.9% between October and December of last year, down from its initial estimate of 1.1%. The figures showed domestic spending was less than first calculated, as was investment and stockpiling by firms. On an annualised basis, economic growth was 3.8% in the quarter, down from the initial estimate of 4.6%. The downward revision in economic growth is likely to increase pressure on the Bank of Japan to ease monetary policy. However, with interest rates already down to 0.1%, it does not have much room to move.

 

Greek tax increases designed to curb the European Union’s biggest budget deficit may fail to generate as much additional revenue as the government in Athens estimates, a draft EU report said. This would hinder Prime Minister George Papandreou’s efforts to cut the deficit to 8.7 percent of gross domestic product this year from 12.7 percent in 2009. The Greek parliament last week passed a package of extra tax increases and spending cuts to try to convince the EU and investors that Greece is serious about reining in the budget gap. While the 4.8 billion Euros ($6.5 billion) of additional austerity measures enacted on March 5 “appear sufficient to safeguard the 2010 budgetary targets,” risks remain that increases in value-added tax and fuel taxes may generate less revenue than the government has projected, according to the draft report by the European Commission, which was obtained by Bloomberg News and will be discussed by EU finance ministers in Brussels during week.

 

In the week minutes from the last Bank of England’s Monetary Policy Committee meeting will confirm the latest thinking on quantitative easing.  One of the reasons why it was not pursued will be seen on Tuesday when latest inflation numbers are likely to show that consumer price inflation which is targeted 2pc was running at around 3.5pc last month with a number of economies believing it will advance slightly for the next couple of months before falling away sharply at the back end of the year.  Friday’s official retail numbers will confirm numbers from both the CBI and the British Retail Consortium in that February showed a rise in sales after January’s slump.  Wednesday’s unemployment numbers are likely to show a levelling off at just under 2.5mn or around 7.8pc of the workforce.  Whilst this is much better than had originally been forecast it disguises massively hidden unemployment through part time workers and an increase in those deemed to be economically inactive.  Numbers on the same day will show that those who are in employment are suffering falling real wages with wage inflation likely to be just over 1pc against inflation of 3.5pc suggesting further bad news for consumer spending going forward. Figures published on Thursday by the Office for National Statistics are expected to show that the Government borrowed £14bn in February, £5bn more than the £9bn it borrowed in the same month last year.

In the US Tuesday's calendar starts with government statistics on housing starts and building permits for February, as well as data on export and import prices. But the main event could well be a policy statement from the Federal Reserve's interest-rate committee. The central bankers are expected to keep their target interest rate at a record low of virtually zero, while maintaining their language implying rates will remain unchanged for an extended period. Mid-week economic reports include data on producer prices for February, followed by data on consumer prices on Thursday.  Weekly data on the number of Americans filing claims for jobless claims will also be released on Thursday, along with an index of business activity in the Philadelphia region, and the February index of leading economic indicators.

 

Gold futures for April delivery fell $6.50, or 0.6 per cent, to $1,101.70 an ounce on the Comex in New York, leaving the most-active contract down three per cent last week, the biggest weekly drop since January 22.

Crude oil for April delivery ended down 87 cents, or 1%, at $81.24 a barrel on the New York Mercantile Exchange. For the week, crude lost 0.4%. On Friday, the International Energy Agency revised up by 70,000 barrels a day its oil demand forecast for both 2009 and 2010, pointing to growth in Asia. Global oil demand is expected to rise by 1.6 million barrels a day, or 1.8% year-on-year, to 86.6 million barrels a day in 2010, the IEA said in its monthly report. In contrast, demand is estimated to have contracted by 1.2 million barrels a day, or 1.4% year-on-year, to 85.0 million barrels a day in 2009. After five consecutive quarters of decline, global oil demand began growing again on a yearly basis in the fourth quarter of 2009, the IEA said. However, this year's demand growth will be fuelled entirely by emerging countries, particularly those in Asia. The forecast for demand in the OECD, or the developed economies, was revised lower by 120,000 barrels a day for 2010, given very weak readings in January, most notably in Europe, the IEA said. In contrast, China's apparent demand surged 28% year-on-year in January. The Asian nation is expected to account for almost a third of global oil demand growth in 2010. The IEA has been among the more bullish forecasters in the oil market. Other analysts think issues like high U.S. unemployment, weak lending and economic problems in Europe will thwart consumer activity, all of which will retard global oil demand growth to just around half the rate the IEA is currently projecting

 

The past week saw the first anniversary of the global stock market rally when according to the MSCI World Index global markets hit rock bottom on March 9th 2009.  Since then the global index has rebounded by just over 70pc.  At that time there was a realistic worry about rapid deflation, a serial banking crisis and a wave of protectionism.  Whilst most of these menaces have now receded they are not gone. Stock Market investors have welcomed the fact that companies are now sufficiently in control of their short-term destiny to remain upbeat.  Unfortunately there are far too many wounds from the financial crisis, which remain unhealed to say that we are in the clear.  Central banks are still being extremely generous with credit and unemployment rates remain unacceptably high and whilst the numbers may appear to be levelling out my concern remains that they will again move upwards in the months ahead.  One of the reasons for this is that the world remains far too borrowed for its own good and de-leveraging will continue for quite some time yet.  So whilst the financial system is no longer in crisis this newfound exuberance is itself a major cause of concern.  Historically a strong twelve months in stock markets has usually been followed by a mediocre performance.  I continue to unfashionable predict markets are far too short term and blinkered and are failing to reflect the more medium term fundamentals of the situation. Mohamed El-Erian, the group's chief executive of PIMCO believes most analysts are still using "backward-looking models" that fail to grasp the full magnitude of what has taken place in world affairs since the crisis. PIMCO estimate that about 40pc of the global economy is in countries where governments are running deficits above 10pc of GDP. My main worry is that all these governments are predicting strong growth going forward, whilst expecting a trouble free journey via stimulus withdrawal and deficit reduction and plans for Zero deficits remain firmly under wraps. The global economy has been so distorted by government aid that it is near impossible for anyone to be entirely sure how it is functioning and what will happy when the stimulus money runs out and has to be withdrawn.

 

David Scott Senior Stockbroker