market watch from www.LegalandFinancial100.co.uk

In a Liberal dose of Conservatism, the new coalition Cabinet met on Thursday and around the table were 18 Conservatives and 5 Liberal Democrats.  In a sign of the public spending squeeze to come, the first Cabinet meeting agreed to a 5 per cent ministerial pay cut in a very clear message that the new coalition is planning a tough public sector pay squeeze.  During the campaign the Tories planned to begin deficit reduction this year, with £6 billion worth of spending cuts.  Commenting in the week the Governor of the Bank of England said a possible £6 billion worth of cuts this year will not dramatically alter the outlook, but it will reduce some of the downside risks associated with higher borrowing costs, as it will appease an increasingly nervous world of creditors in the bond market.  The Governor also warned that doing nothing was not an option and the Government must immediately act on the deficit.  Presenting the latest quarterly inflation report, Mervyn King warned, as I have also consistently said, that the financial crisis is not yet over and is probably only half way through and left open the prospect of further quantitative easing.  King has warned frequently about the dangers of excessive debt and the speed of the European crisis emanating from Greece would appear to have convinced him that urgent action is required.  As economic data on unemployment rose to its highest level in 15 years, the Governor highlighted bigger downside risks to growth in the shorter term than the bank had previously anticipated.  The bank warned that the weak recover in the domestic economy would be dampened by necessary fiscal tightening, whilst there was also risk that the current turmoil in financial markets, sparked by fears over Greece’s credit worthiness, would hurt both demand and business activity.  The quarterly inflationary report forecast that inflation will fall to 1.4 per cent in two years time if interest rates rise as the market currently expects.  If interest rates remain at 0.5 per cent, inflation will be below the Bank’s 2 per cent target in two years, according to the Bank’s projections.  The report clearly signalled that the Bank has no intentions of raising interest rates as quickly as the markets are currently predicting and that they are likely to stay at 0.5 per cent well into 2011. 

 

The new Government’s emergency budget, which is expected to be on June 23rd, will give clarity on tax increases and some spending plans, although, it has already been indicated that there will be changes to capital gains tax, with non-business assets being taxed at a higher level.  There is also likely to be a return of a time weighted charge and this is likely to see shorter term speculative gains being taxed at higher levels than gains that have been acquired over a longer period of time.  Whilst nobody likes tax increases or spending cuts, there is pain ahead and the coalition has agreed that the bulk of future fiscal adjustments will come from spending cuts rather than tax rises.  I have said for many months that a rise in VAT looks inevitable, and I am even more convinced about this now, although there may be some time delay in the increase in order to help the nation’s economic recovery.  The National Landlord’s Association has called on the Government to redesignate buy-to-let property as a business asset, thus putting it at the lower end of the expected two new tiers of CGT rates.  I believe this is highly unlikely and we may well see a rush of buy-to-let properties being forced onto a weakening property market in the coming weeks.  Of course, we do not, as yet, know the detail of the tax or its implementation date.  The implementation date is unlikely to be much after the emergency Budget and one cannot rule out the fact that it may be retrospectively imposed from the beginning of the tax year, although this is unlikely, as it would set a very dangerous precedent. 

 

A newly created office for budget responsibility will present fresh forecasts for growth and borrowing, which are likely to show that the underlying problem is much greater than originally thought. It may also see some of the Governments off balance sheet items like public sector pensions and PFI brought onto the books which will see debt as a percentage of GDP increase very significantly. They will argue that the Treasury’s forecasts were unrealistic and this new independent body will provide newer numbers, on which the Government will then base forecasts going forward.  In the autumn detailed spending cuts will be outlined, in a spending review covering the next three years. 

Delayed by a week, the Bank of England kept base rates at 0.5 per cent for the 15th month in a row this week.  Towards the end of the week sterling fell off sharply due to concerns about the state of the UK economy after our global trade deficit worsened more than expected in March.  Total imports grew faster than exports suggesting that the weaker pound is failing to provide a significant boost to UK trade.  The UK global goods deficit widened to £7.5 billion in March from an upwardly revised £6.3 billion in February.  Economists had been expecting the deficit to widen only marginally to £6.6 billion.  The data showed the value of exports rose 1 per cent, considerably slower than February 9.5 per cent increase, however, imports were up by 5.2 per cent to £29 billion.  Earlier in the week prospects for the UK economy appeared to be on the up after industrial production surged at its fastest rate in 8 years in March, as manufacturing weakness at the start of the year reverse and the recovery appeared to be gathering pace.  Industrial production rose by 2 per cent, the strongest month on month increase since 2002, whilst manufacturing output jumped by 2.3 per cent.  Economists had been expecting an increase of 0.4 per cent.  The sharp rise in output was driven by a pick up in capital goods production and intermediate goods and energy suggesting that UK companies, in the UK and abroad, were investing again in equipment.  According to the National Institute of Economic and Social Research, the UK economy grew at a stronger pace in the 3 months ending April than the 3 months to January.  Its estimate of GDP in the 3 months to April was 0.5 per cent compared with the previous 3 months period of November to January, which was a rise of 0.3 per cent.  The latest snapshot from the British Retail Consortium and KPMG showed a slump in the high street last month by the timing of Easter and pre-election jitters.  The value of like-for-like sales fell by 2.3 per cent in April, against the 4.4 per cent increase seen in March.  The three month average, which irons out Easter’s distortions showed like-for-like sales up by 1.6 per cent on a year earlier and 3.8 per cent up overall.  The number of house repossessions has fallen over the past quarter to less than 10,000 the Council of Mortgage Lenders reported in the week.  The decline, however, was not enough for the Trade Association to adjust its grim forecast for the year.  The organisation expects 53,000 homes to be repossessed this year, the highest rate in 15 years.  The number of repossessions in the first quarter was 9,800, compared with 10,600 in the previous quarter and 13,200 in the first three months of the year.  Mortgages in arrears totalled 186,300, compared with 196,400 in the previous quarter.  The latest monthly survey of 245 members of the Royal Institute of Chartered Surveyors said prices are still going up.  In April, 17 per cent more surveyors said prices will rise rather than falling, up from 9 per cent in March.  The average number of homes sold per surveyor rose to 17.4 over the 3 months to the end of April.  I personally believe that this reflects the pre-election buoyancy of the housing market and for the remainder of the year the effects of this are likely to turn abruptly downwards.

 

Unemployment in the UK rose by 53,000 to 2.51 million in the 3 months to March, the highest level for more than 15 years, underlying the weakness of the market.  The Office of National Statistics also revealed the number of people who claimed jobless benefits fell by 27,100 in April, after a revised fall of 32,700 in March.  Analysts had been predicting a fall of 20,000 and reported that the number of inactive people of working age increased by 88,000 over the quarter to reach a record 8.17 million.  Almost half of this increase was because the number of students not in the labour market was increased by 43,000 on the quarter to reach 2.3 million.  The number of people in work fell 76,000 in the 3 months to March to 28.9 million, pushing the employment rate to a 13 year low of 72 per cent. 

 

The European bailout was described as “shock and awe” and was an attempt by the European Governments to put themselves one step ahead of the financial markets, for the first time in more than 6 months.  The $1 trillion is clearly impressive, although markets await the finer details with a significant element merely promises rather than hard cash, which the market would like to have seen.  I believe that the deal has merely bought the EU time to sort out what was becoming an imminent implosion of the Euro zone. The troubled nations need to be put on a sustainable footing and it is these thoughts that are likely to percolate into the markets over the coming months.  In the short term the European Central Bank is becoming the buyer of weaker economy debt. The ability of these Nations to repay remains in question, with markets only willing to lend at exceptionally high rates of interest.  Due to the extent of these measures the European Central Bank emphasised that countries had to commit themselves to meeting harsh fiscal targets and, if they do not, which I believe is highly likely, due to public resistance, then the European Central Bank will be left with devalued paper and further problems.  Over recent weeks foreign creditors, particularly China and emerging powers, have lost confidence in the EU’s ability to manage itself and have steadily withdrawn from buying riskier bonds, which I believe will continue and this leaves the euro zone very vulnerable to further sell offs.  The hope of the plan is that Portugal and Spain, which were uncharacteristically singled out in the Finance Minister’s communiqué, will be allowed breathing space to sort out their fiscal problems, without having to access the new bailout funds.  Both countries in the week announced further austerity plans, both of which met with significant resistance from the countries citizens.  The day after “shock and Awe” was announced, credit rating agency Moody’s cautioned investors that two of the euro zone’s hardest hit countries are not yet out of the woods.  In the last month Moody’s has said several times that debt strapped Greece and Portugal are under review for future downgrades to their credit ratings and in a report on Monday the agency said that these downgrading could occur within the month and that Greece’s downgrade would probably be more substantial than previously indicated.  The European bailout will cost the UK a maximum of £8 billion according to former Chancellor, Alistair Darling. Britain’s reluctance to help out the Euro zone was clearly behind French officials warning that if the British were to get into difficulties, then they should expect no favours from Europe.  Jean-Pierre Jouget said the UK would have to fend for itself if ongoing political uncertainty led to a meltdown in financial markets. As the head of the French market regulator, a former European minister and someone who is close to President Sarkozy, his comments should not de dismissed lightly. French president Nicolas Sarkozy, threatened to pull his country out of the euro if other EU countries, especially Germany, did not agree to help rescue debt-laden Greece according to a report in El País newspaper quoting Spanish Prime Minister José Luis Rodríguez Zapatero. The French president made this threat at a Brussels summit of EU leaders ahead of the rescue plan. Sarkozy, demanded "a compromise from everyone to support Greece ... or France would reconsider its position in the euro," according to one source cited by El País. "Sarkozy went as far as banging his fist on the table and threatening to leave the euro," said one unnamed Socialist leader who was at the meeting with Zapatero. "That obliged Angela Merkel to bend and reach an agreement." A different source who was at the meeting with Zapatero told El País that "France, Italy and Spain formed a common front against German and Sarkozy threatened Merkel with a break in the traditional Franco-German axis." El País also quotes Sarkozy as having said, according to another of those who met Zapatero that "if at time like this, with all that is happening, Europe is not capable of a united response, then the euro makes no sense". Former Federal Reserve Chairman Paul Volcker speaking in London in the week said that he’s concerned that the euro area may break up after the Greek fiscal crisis that sparked an unprecedented bailout by the region’s members. “You have the great problem of a potential disintegration of the euro the essential element of discipline in economic policy and in fiscal policy that was hoped for” has “so far not been rewarded in some countries.”

 

On a much more positive note, the German economy performed significantly better than expected in the first quarter of the year.  Gross domestic product in Europe’s largest economy expanded by 0.2%, compared with the previous 3 months, the country’s Statistics Office reported at the start of the week.  It also said Germany’s economy grew by 0.2% in the fourth quarter of last rise, increasing the previous forecast that had shown GDP being flat.  During the week the Germans, however, woke up to the harsh reality of the full impact of the euro bailout, as the nation was told that it will have to make savings more extensive than at any time since the end of the Second World War, with education and family welfare taking big hits.  The Government announced their plans just days after the German Cabinet gave the go ahead for Germany’s €123 billion contribution towards the rescue package to stabilise the Euro zone and this figure could rise to €150 billion if needed.  When Merkel’s Government came into office in October, it promised tax cuts and instead policy makers are now talking of increasing taxes to fill a €10 billion fiscal gap.  For a country where borrowing limits are enshrined in statute books, and where credit is almost a dirty work, it is not surprising that wage freezes of recent years have made German’s bitter against what they see as excess elsewhere within the community.  The European bailout has forced Germans to reluctantly acknowledge that they are the major power in the euro zone and public reaction to the situation saw Angela Merkel’s Christian Democratic Party lose significant regional elections at the beginning of last week. During the week the Italian Government successfully got away a €3 billion euro 2015 fund raising, easing some fears that contagion could see Italy also topple. This is encouraging as Italy has the world’s third largest amount of debt after Japan and the US at £1.76 trillion and any hints of credit problems will have global ramifications.

 

In the week the International Monetary Fund suggested that the Greek’s economic recovery will be even more painful than anticipated, with slow growth rates and rising unemployment compounding the problem.  Ultimately I believe that whilst Greece may not be allowed to default, there will be a restructuring of its debt, most probably extending it life over a greater time period.  If it is restructured more harshly and bond holders are forced to take a loss (a haircut), then it will be very bad news for the whole of Europe with the possibility of banks and sovereign states toppling over. Comments by the Chief Executive of Deutsche Bank that Greece may be unable to repay bond holders is very much in line with my thoughts and that there will be debt restructuring, not only in Greece but in a number of other European countries. It will only be once the problems are recognised and dealt with that we will be able to start rebuilding sustainable growth.

 

Although Portugal recorded the strongest economic growth in the European Union in the first quarter of this year, lifting prospects of a recovery, this was not enough to stop the Government announcing a harsh austerity package in the week.  At the start of the week the National Institute of Statistics reported Gross domestic product had expanded by 1% compared with the previous 3 months and this was Portugal’s highest quarterly growth since 2005 and compares with the EU average of 0.2%.  Slovakia was the only EU country with higher year on year growth at 4.6%.  The Portuguese Government has approved a series of measures, including tax increases and salary reductions for politicians and other public employees, intended to speed up the country’s reduction of debt.  Government Ministers and other State employees will have their salaries reduced by 5% starting this year and workers, up to a certain level, will pay a special 1% tax on their wages and those earning more than the amount will pay 1.5%.  Companies with profits of more than €2 million will pay an extra 2.5% tax on their profits and Value Added Tax will rise by 1% across all categories.  Portugal had a budget deficit of 9.4% of Gross Domestic Product in 2009 and in April the Government approved a plan to cut it to 2.8% of GDP in 2013.  In light of the European difficulties they have accelerated there plans to cut the deficit to 7.3% of GDP for this year and 4.6% of GDP next year from the previous targets of 8.3% in 2010 and 6.6$ of GDP in 2011.  Spain’s Government has also announced a 5% cut in civil service pay, also as part of an accelerated plan to cut the country’s deficit and has set about cutting another 1.5% of Government spending. Spanish Civil servants will have their pay cut by 5% this year, with a freeze next year and the Prime Minister and other members of the Government will take a 15% pay cut.  The new measures should bring the deficit down from 11.2% of GDP in 2009 to just over 6% of GDP in 2011.  Other measures include a €6 billion cut in public sector investment, €1.2 billion in savings by regional and local governments, a freeze on pension payments and abolition of a €2,500 child birth allowance from next year.  In response to the measures, Spanish trade unions on Thursday called for a public sector strike and demonstrations against an emergency austerity plan.  .  For a Socialist Government that promised tax cuts and no public sector pain when canvassing last week’s U-turn by Spain’s Prime Minister shows the seriousness of the situation. 

 

In the week gold rose above €1,000 a troy ounce for the first time and hit a fresh record high in dollar terms on Friday of $1,248.95 a troy ounce, before falling back to $1,239.65. Crude-oil futures fell to their lowest prices in three months, down nearly 4% on Friday, Crude for June delivery, the most active contract, lost $2.79, or 3.8%, to close at $71.61 a barrel on the New York Mercantile Exchange. Oil futures were down 4.6% on the week and had fallen in six of the past seven days. Prices are now at levels last seen in February levels. The European Central Bank president, Jean-Claude Trichet, warned this weekend that Europe faces its worst crisis since the Second World War as he called for a "quantum leap" from euro zone countries in getting a grip on their finances. With political leaders across the euro zone lining up to blame the financial markets for their economic plight, Trichet said it was Europe's governments that were responsible for the euro's slump, rather than currency traders and speculators.

 

Whilst the two Iberian nations are taking constructive action in order to reduce their borrowing deficits, they are still going to be borrowing heavily. All the plans are about deficit reduction not debt reduction, which means like any credit junky the two nations will still need to borrow as they cannot support themselves. They will therefore remain at the mercy of international lenders who may well decide that the risks outweigh the rewards and without funding without giving any warning.  The current situation is likely to see bond yields rising further as creditors become more nervous and discerning and this will put pressure on the very economies that need quick and cheap money due to there poor economic situation.  Ultimately, the budget cutting for these Iberian twins is only one priority the second and arguably most important going forward, if Europe is to survive in its current structure, must be to restore competitiveness within the Euro zone and that will mean Germany having to change. Large creditor nations cannot continue to suck the economic life out of the rest of the region and this for an export model economy like the German may be just too much to stomach. The forthcoming adjust will be painful for all and it has been seen in the last few weeks that the pain will be for all and not necessarily in the most obvious of places.  This will mean reforms to both the financial and labour markets and these are unlikely to go down well with European citizens.  Ultimately, however, these nations need to become as competitive as the best within the euro zone, otherwise they will continue to see their economic strength drained away as they become weaker and the strong like Germany become stronger.  Having allowed Germany, over the last 10 years to increasingly become more economically efficient, not only do these nations need to match the annual efficiency savings of the Germans, they also have almost a decade of slippage to make up. Ultimately, I do not believe that these nations are capable of doing this and, therefore, this will remain a major destructive force within the political union.

 

Chinese inflation and housing prices continued to accelerate last month. Consumer price inflation increased to 2.8 per cent in April from 2.4 per cent the month before, its highest level in 18 months although still below the government’s target of 3 per cent. Factory gate inflation jumped to 6.8 per cent from 5.9 per cent. Adding to the fears of overheating, house prices increased by 12.8 per cent in April from a year earlier, the fastest rate of increase since records began five years ago, although sales volumes in many cities have already slowed dramatically in recent weeks as a result of government policies aimed at discouraging property speculation.

 

In an early vote of confidence for the new Government, bond market investors eagerly bought the first Gilt auction of the new regime, when £1.1 billion of 2012 Index Linked Gilts were oversubscribed 2.5 times.  This was slightly better than the sale of £2.5 billion worth of 2027 Gilts on Tuesday, which was 2.47 times oversubscribed.  The new coalition will have a honeymoon period and it is important that this is used effectively.  Whilst individual parties have enough difficulties in holding themselves together, the strains within a coalition could prove to be destructive and these fault lines are likely to increasingly appear over time.  That said, investors at the current time are more concerned about the problems in Europe and the severe worsening in the euro zone crisis has shown that it is investors, not politicians, who will dictate the timing of needed cuts to Government spending.  Following the Greek contagion the government is likely to push for harsher cuts than what they had previously suggested in the run up to the General Election.  Ultimately, we remain in the credit crunch and there is no easy way to solve the problem without some pain.  Weak-willed politicians have consistently taken the easiest political route which has compounded the problems over many years.  Ultimately, there is too much debt, too much Government spending and a massively unbalanced global economy.  These are the root causes of the credit crunch and need to be addressed and cannot be without pain being taken proportionately across the Western world.  The new Cabinet’s decision to take a pay cut, the first of many I fear within the public sector, is being portrayed as a sacrifice for the national good by a national government.  Countries whose austerity plans have been forced upon them, like Greece, Portugal and Spain, have subsequently seen national strikes and if anything is certain the UK is likely to see increased industrial action from the public sector over the coming year as reality bites. Taxing times lie ahead and markets are likely to remain under pressure.

Leeds Financial