Economic review of June 2007

It transpires that the Governor of the Bank of England was outvoted when he wanted to increase interest rates to 5.75% in June.

This is only the second or third time this has happened since 1997; the most recent having been when he voted against the August 2005 cut to 4.5%. One has to ask whether we might not be facing such large increases now, had his opinion held sway then; many commentators confidently expect to hit 5.75% during July and do not rule out 6% by the end of the year. Conversely, he does have a “hawkish” reputation on interest rates and had he been successful in preventing the cut eighteen months ago, there might have been other implications, such as too much of a slowdown in the economy.

What is more likely, in our view, is that the decision to increase interest rates in August 2006, while unexpected at the time, should perhaps have been a full half percent, rather than a quarter, in order to give consumers a short sharp shock and reduce borrowing. It might have hurt at the time, but might have reduced the need for subsequent increases.

However, there are indications that borrowing is now falling, with new mortgage applications now being at the lowest rate since September 2005 and consumer credit having fallen to £500 million, its lowest level since early 1994.

“Doves” on the Monetary Policy Committee hope that previous increases have therefore done the trick. But as Gordon Brown (while he was still Chancellor of the Exchequer) recently announced that future appointments to the MPC would be by open competition (with the Chancellor making the decisions) who knows how the balance of “doves” and “hawks” will go in future?

Let us just be grateful that we are not living in New Zealand, where interest rates have just risen to 8% or South Africa, where they are now 9.5%.

However, 10-year bond yields in Germany and the UK are up and Deutsche Bank says that 820,000 UK mortgages that are due for re-setting during the second half of this year could face interest rate hikes of 1.4%. (Source: Daily Telegraph 14/6/07).

Good luck to the new Chancellor
The new Chancellor of the Exchequer, Alistair Darling, will have the unenviable “advantage” of having his immediate predecessor as his neighbour and boss. This will make it rather difficult for him to follow tradition and blame everything on the previous incumbent …

And since he has inherited a government spending deficit of some £170 billion, accumulated since 2003 (it was £34 billion last year alone), Darling may need some helpful advice. Brown did an excellent job in maintaining the low interest rates and steady economic growth that he inherited from the mid 1990s, but the challenges facing the new Chancellor include:

• Pension reform, which is still a mess;

• A massive deficit in the current account – the trade deficit has grown form £7 billion in 1997 to £59 billion, in 2006;

• A manufacturing base that has barely risen during the last decade, and now represents less than 15% of GPD – having lost 1.25 million jobs over the period (Source: Daily Telegraph 10/6/07).

If it quacks like a duck …

Debate over the private equity / venture capital sector rages on regarding the level of tax they pay. The problem is that as most money is generated as capital gains on business assets, which only attract capital gains tax at 10%, once the qualifying period of two years has been passed; yet to all intents and purposes, this appears to be income, which should be taxed at 40%. The argument is that if it looks like income, it should be taxed as income.

While we may have some sympathy with this view, it is important to remember that “taper relief” against CGT on business assets is something that anyone can benefit from; so before we allow the Chancellor to remove this so-called loophole, it would be as well to consider whether this could affect a large number of investors.

What is more, investors behind these funds could move off-shore if they do not like the regime and, whether or not we like the way they behave, this could harm the economy even more. Caution should be the watchword; but looking at the way Gordon Brown ignored advice about the adverse impact of his £5 billion-a-year raid on pension funds in 1997, there is little hope that his successor will be any more open to argument.

Following on from last month’s article on Venture Capitalists, it is interesting to note that Cadbury Schweppes has decided to rationalise its business on its own initiative, taking steps that look remarkably like those a VC might follow after a takeover. If this increases shareholder value, while safeguarding jobs and service standards, it is to be welcomed.

Inflation
The headline rate of CPI inflation fell to 2.5% during May, from 2.8%, but with interest rates looking set to rise yet again and oil prices still on an apparently upwards trend, it is difficult to see that the Bank of England’s prediction of 2% inflation by the end of next year is realistic. Others are suggesting that 5% by mid 2008 is more likely and this will impact on those with occupational pension schemes that are subject to Limited Price Indexation (that is the RPI applies until rates exceed 5% and then a cap cuts in). Commentators say that there is simply too much money in the economy for inflation effectively to be slowed.

Markets (Data compiled by the Insurance Marketing Department Ltd.)
After three months of growth virtually across the board – and with fears that interest rates will rise even further (as well as a degree of economic uncertainty brought about by concerns over the sup-prime lending market in the US) – it is hardly surprising that the main indices softened last month.

The FTSE100 eased by -0.20% during June, while the mid-cap FTSE250 fell by a substantial -4.12%. However, when you consider that it had put on almost 30% during the previous 12 months, this could be seen as something of a correction. Of the main indices we track, only AIM market saw a positive trend in the UK last month, rising by 1.11% to bring its 12-month growth to 12.59%, just behind the FTSE100’s 13.28% over the same period.

Elsewhere, in the US both the Dow Jones and Nasdaq100 lost ground, by -1.61% and -0.05% respectively, but the Eurostaxx50 put on a modest 0.47%, while the Nikkei225 managed a respectable 1.47%. All the indices we track are up over the first half of 2007.

Unfortunately, Brent Crude 1-month futures were also up last month by 5.17% to US$71.35, meaning that oil costs more than 10% more than this time last year and 17.24% more than at the start of the year. This is clearly putting pressure back on inflation and must be one of the considerations taken into account by the MCP at its deliberations in July. However, as we have previously reported, many people are deeply worried about the increasing money supply (as measured by M4, the broadest interpretation that includes credit) so an interest rate hike remains on the cards.

Sterling has also topped US$2, possibly in anticipation of a July interest rate hike, although as the Euro also rose against the US$, this could point just as much towards relative weakness within that currency.

Quit smoking, but who pays the price?

With a national ban on smoking in public places effective from 1st July, it is anticipated that many people will take the opportunity to stop smoking altogether. While this should (according to the medical experts) lead to an improvement in health and a reduction in deaths caused by passive, as well as active, smoking, it would also lead to a massive reduction in government revenue.

And with the shortfall in government revenue indicated above, this should be a matter of concern for everyone. Alistair Darling will have no choice but to cut government spending, borrow even more or increase taxes. Since few Ministers have the stomach for taking on the Civil Service in order to achieve much-needed economies, and further borrowing will simply push the country further into debt, there seems to be little alternative to higher taxes. It has yet to be seen whether the new man will be as adept at introducing stealth taxes as his mentor.

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