Economic review of May 2007

Interest rates were raised to 5.5% this month, but this conceals the real story; that the Monetary Policy Committee seriously considered a 0.5% hike to 5.75%.

There are those who argue that the harder decision should have been taken, because the threat of inflation is much greater than some allow for. In fact, there is concern that the 13.3% growth in M4 (which is the broadest definition of money supply) over the last year is a real problem for the economy. Certainly this is the highest level for 16 years and could well lead to “demand-pull” inflation – that is inflation caused by people having too much money to spend, so manufacturers can afford to raise prices without fear of demand falling off. Interest rates round the world

The British Retail Consortium say this isn’t happening because sales for the year to April were only 2.4% ahead, compared with 3.9% during March. There is also some evidence to support its view in the employment market, where an influx of immigrant labour appears to be holding down pay levels. Not only does this act to depress consumer demand, but it also reduces “cost-push” inflation. Unemployment levels in the UK have risen from 4.8% to 5.7% over the past two years, even though the number of people in employment is actually up by 300,000 to almost 29 million, over the same period. Of course higher interest can rates hurt business by increasing operating costs. But if this also results in a raised value of Sterling, exports become more expensive and the cost of competing consumer imports falls; so it is important that borrowing does not become too expensive.

It is therefore open to question whether it was, after all, such a brilliant idea to give the Bank of England (BoE) complete autonomy over interest rates, exactly ten years ago this month. Hailed then and now, variously as a master strike and as a negation of responsibility, it is certainly true that the past decade has been one of apparent stability. The problem is that the BoE has been something of a one-trick horse; it has responsibility for controlling inflation but can only manage interest rates to do so. As we are now seeing there are other factors driving inflation, such as money supply, over which the Bank appears to be powerless.

The inflation figure for April (as measured by the CPI – the Government’s target measure) was 2.8%, down from 3.1% in March. This is apparently driven by falling energy costs, although oil prices are still 11% higher than at the start of the year.

As various commentators have pointed out, however, many people suffer personal inflation rates well in excess of the “headline” figure, with pensioners leading the field with a rate of more than 6% (almost 8% using the broader RPI basis), closely followed by the “middle class”, according to data produced for the Daily Telegraph by Capital Economics (DT 16/5/07). Only young professionals and those living at home have rates of inflation below the published rates.

Venture capitalists

There has been considerable comment over recent weeks about the role of venture capitalists (VCs) in investment markets. This has been highlighted by some very public swoops on large companies and reports that there is an estimated “war chest” of more than £1,000 billion available for the right purchases.

This form of investment commonly includes massive “gearing” – that is borrowing from banks and other investors – in order to provide the finance. In many cases, profits are made by rationalising the business (which generally means cutting costs such as staff) and selling any parts of the business that can easily be hived off. This raises the question whether it is in the interests of investors generally that this should take place; and there are several alternative answers to this.

The existing shareholders of a company that is subjected to a VC-backed takeover have a choice over whether or not to sell. If they determine that the existing management are doing a good job and can provide the best long-term value, then they will not sell. In many cases, however, there is massive potential for cost savings and if the current regime is not offering the best return on capital, then it may well be in everyone’s interests that a change be made. This can result in a loss of jobs due to rationalisation, but those posts may not have been particularly secure in a business that was not maximising its potential.

The position is slightly different for those investing indirectly in “target” companies, perhaps via unit trusts and other collective investments. They are effectively disenfranchised; but as they are relying on the expertise of the investment managers they employ, they should be no worse off.

It is the tracker funds that could come off worst if the threatened move into FTSE100 and FTSE250 companies accelerates. This is because those firms being “taken private” will fall out of the index altogether to be replaced by other companies that may be less attractive to investors. The “turn” made by the venture capitalists and their backers may not benefit investors in tracker funds if the revised nature of the index no longer reflects the characteristics originally perceived to apply. The position with index funds will differ, because these are invested according to the strategic characteristics of the appropriate fund, rather than investing in most or all of the actual companies making up the fund.

There are, however, some special situations that require careful thought. One such is the insurance company sector, where there are potentially massive sums that could be realised by VCs – or, indeed other investors – which are currently tied up in what is called the “estate”. This is money within the life fund that is not directly attributable to individual policyholders, but is there to provide security and investment flexibility. Strict rules govern how these assets are applied, but several companies are already seeking to “buy-out” existing policyholders’ interests in the estate, in order to allow some of the money to be attributed to shareholders.

Markets

Building on last month’s success, all the main indices we follow were up during May, including the Nikki225, which, with a 3.48% rise, has more than recovered its losses of previous months. The Dow Jones lead the way with an impressive 4.32% rise, while the FTSE100 increased by 2.67% - now having achieved a 2% plus rise in each of the last three months. The Eurostoxx50 also impressed at 3.15% up over the month.

Over the past three months, the FTSE100 has gained 7.29%, while the Dow Jones is 11.08% higher and the Eurostoxx50 stands at plus 9.34%.

Sterling lost just over 1%. against the US Dollar, which should please exporters, but eased up 0.43%. against the Euro; this means that the Euro lost 1.47%. against the US Dollar. Sterling now stands 5.7%. above its US Dollar level of a year ago.

Pension funds

Good news for the top 200 UK pension funds; according to a recent survey, they are back in surplus for the first time in six years. This is largely due to higher bond yields and a healthy bounce back in the FTSE100 since the start of the year. It has taken this long for them to recover from Gordon Brown’s £5 billion a year tax raid on pensions. However, as two thirds of all defined benefit (final salary) schemes have closed since 2000, there is little cheer for thousands of pensioners whose prospects have been damaged by what has recently been revealed as a political decision in the face of all advice.

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