We're All Doomed - Part 2

Hate to say I told you so… but sadly in this case, I told you so! Things are getting increasing gloomy in the economy – you only have to look at the latest ‘terrible’ unemployment figures (I did say previously that the private sector wouldn’t be able to soak up the public sector fall out – people were fooled with the lag effect from the Government first announcing austerity measures and the reality of when it kicks in), depressing manufacturing data and stagnant house prices to see that we’re not getting out of this mess any time soon. Additionally, the Euro zone crisis is hanging over us like a dark spectre.

So what are the powers that be doing about it? Well whilst acknowledging that the unemployment statistics were ‘disappointing’ David Cameron has firmly rejected criticism and said that he would stick to his plans to reduce the deficit of nearly 10%.  

So what now Mr Mainwaring? Leading economists have called for George Osborne to announce a job-creation package in his Autumn Statement next month as they are concerned that the latest £75 billion quantitative easing scheme is unlikely to transform the county’s economic prospects.  

The Chancellor will be of course reluctant to do this as the plan has delivered ‘record low interest rates’ and in altering his course may upset the ratings agencies who may then look again at Britain’s credit rating. Mr Osborne also has the added concern that public sector borrowing has increased sharply, higher than economists had expected and is therefore likely to miss his targets for cutting Britain’s deficit. But maybe that’s a gamble we should take at this stage.

It really is a fine balance. In my view I think the Government should be a little more flexible and show that it is willing to listen, be less rigid in its approach and consider other options. We need to bring back some consumer confidence fast.

Making sense of the markets

What’s happening out there I hear you cry? Well debt markets are still in a bad place. In effect they have never really been entirely fixed from the original credit crisis 4 years ago brought on by optimistic overleveraging by banks which have stimulated economies far too much and led to unsustainable asset price inflation. There was a sense that things had recovered but since July they have slipped back again. In truth, it isn’t because they have got worse, its more to do with the earlier optimism slipping away and realisation that things are still fundamentally in a bit of a pickle. They have been since August 2007 when this all kicked off.

Today we are seeing banks building up capital and liquidity to more prudent levels. Good news then. Well yes however what this does is to remove, by a geared factor, the amount of credit available in markets. No wonder economies are slowing and stopping. We have seen many analysts lower their growth forecasts for the UK but my expectation is for the UK growth to go negative.

Unfortunately while this is going on a negative feedback loop is initiated whereby slowing economies engender higher levels of defaults which eat into banks Tier I capital ratios which causes them to reserve more and so more capital is taken out the system on a geared basis and so on and so on….

I mention this as the background to the markets as I see them. Add to all of this defaults and other shocks in Eurozone and elsewhere, plus ongoing problems in the US and it all gets a lot more troubling. Markets don’t like shocks (unless you are a trader – short selling and so on – volatility is where a lot of money can be made).  So we have a nervous global financial market looking for some clarity and strong signals from leaders as to impacts on economies, markets and banks as a result of default/no default. And they aren’t tending to get it, notwithstanding the recent approval from Germany to expand the powers for the EU’s main bailout fund. We have the usual market reaction to this – large swings in market prices on the back of comparatively small amounts of news.

So impact on UK? Definitely. We are less exposed to Greece than some countries but are not immune. We have larger exposures to countries like Ireland (which seems to be doing a good job in recovering at the moment). What is the extent of the impact – impossible to say right now. The entire market has seen Greek default as a near certainty with 2 models: unplanned default or planned default.

My view is that default itself seems to be a dead cert. It looks like the Europeans are working on plan B and buying enough time with the latest bail out to move to Plan B – the planned default with banks bolstering their capital in anticipation. As I mentioned though, losses or increases in capital to meet potential losses have a multiple effect in the amount of credit and liquidity they remove from the markets. This is already happening and I suspect will get worse before it gets better.

Let Battle Commence

So the lines are drawn. In one corner sits Confederation of British Industry director general John Cridland saying that the Government would be ‘barking mad’ to push forward with plans to ring fence UK banks given current grim economic conditions. And in the other corner sits the Chancellor George Osborne and Vince Cable taking Mr Cridland to task signalling their backing for the ring fencing plan.

It will be interesting to see what comes out of the final report to be presented by the Independent Commission on Banking (ICB) on September 12. Its provisional prescription for higher capital requirements, bail in provisions and a measure of separation between retail and investment banking has certainly shaken up the banking industry.

I can see both sides of the argument and whilst I agree that the timing isn’t ideal, my view is that short term pain is needed for long term gain and these suggestions are pragmatic and necessary.

Of course there will be huge amount of costs and disruption in setting up a new system with potentially higher funding costs which could ultimately get passed on to the consumer. It’s natural for banks to recoil against any change to the way they operate. So what will it mean for the mortgage industry in terms of supply of credit and cost of funds?

Difficult to answer and as usual there are two sides to this. By separating the investment bank activity from the ‘normal’ banking you take away the cross benefit to the retail bank from investment banking activities. How so? Investment banking allows banks to run a significantly leveraged model through trading and derivative activities which require significantly less capital than lending to you or me. The profits to be made are huge and across an integrated bank these allow the bank to maintain efficient balance sheet ratios and subsidise costs of lending activities.

So without these ‘subsidies’ the costs are likely to go up for the consumer at least in the short term. But you have to look to the future.  By taking away these other profitable albeit racier activities you remove a good degree of risk to banks.

The solution is to be realistic and pace its implementation. If we take the opportunity now to make these changes, over the longer term we will be left with a more robust financial system and ultimately it will be in the taxpayer’s interest.

Life's a Riot

So we have more gloomy economic data to contend with on top of the riots and turmoil in the markets? Manufacturing data fell by 0.4% in June and Britain’s deficit in goods trade with the rest of the world widened from £8.5bn to £8.9bn in June. Not looking good and I guess it’s hardly surprising that we are starting to hear more of the words ‘double dip’ from many analysts. Oh to be in England…! Then again the rest of Europe and the US don’t look so hot either at the moment either.

With this backdrop it is hardly surprising that Mervyn King and his friends at the Bank of England have revised UK growth forecast for the year from an always optimistic 1.8% to a not so healthy 1.4%. I predicted this would happen in June and  sadly I think he may have to revise this forecast down again in the next couple of months; things don’t look to be getting better anytime soon and not only do we have to look at economic data at home but what’s happening overseas also. Surely it’s only time before the Office of Budget and Responsibility will follow suit very soon forecast down from its buoyant forecast of 1.7% for the year. 

For me, I think 1.1% for the year is more likely a figure. And that’s me being optimistic!

The Black Hole

Santander UK recently announced a 21% drop in gross mortgage lending for the first six months of 2011 compared to the same period of 2010 and similarly today Barclays reported a drop of 10% for the same period. Santander said it reflected the weaker pipeline from the last quarter of 2010, representing reduced consumer demand.

I’m led to believe this scenario is not uncommon and other lenders are facing a similar drop in gross mortgage lending for the first six months of the year - and beyond.

Surely therefore this makes the CML’s revised market forecast for 2011 predicting an increase in gross lending to £140bn from £135bn implausible? This seems to go against other data which suggests general stagnation of the market due to severe rationing of funds by lenders and lack of demand from would be buyers prompted by fears of a downturn in the economy including higher unemployment and weaker consumer confidence.

I appreciate that it is sometimes good to talk the market up. However it is very difficult to see exactly where this extra lending is coming from. Methinks another revision is on the horizon.

A change of heart

I’m worried that my blogs are becoming a little predictable with their gloomy outlook on the economy and the world generally. All I seem to do is write bad news stories although arguably I just write about what I see. However even I was starting to get down so this week I wanted to find something positive in the economy to write about. I was determined to find some good news.

And on the face of it I found some.

So three cheers then. The Office of National Statistics claims unemployment is down. And inflation has fallen. I guess therefore we can celebrate and go on a shopping spree down the High Street then.

Sadly not the case. It is true that unemployment has fallen by 26,000 in the three months to May. This is particularly heartening for the 16 - 24 year olds where the latest figures show a drop of 42,000 in the three months to May to 917,000. However looking beyond the headline figures there are more worrying statistics. For example, the claimant count is up rising 24,000 in June to 1.5m, there are 5.4 unemployed people vying for the same job plus there is evidence that most young people are putting off looking for a job and are going back into full-time education which accounts for the drop in figures. (The real test will come in September with the yearly influx of school-leavers and graduates into the market.)

And what of inflation? Well it turns out that the reduction in the CPI was largely due to the early summer sales, with prices for games, toys and audio-visual equipment all falling. The cost of staples – such as bread, meat, fish etc- continue to soar and will add to concerns about household finances. So despite the surprise drop in inflation, economists still reckon CPI is likely to breach 5% in the autumn as higher utility bills kick in. So the analysts say this is a blip.

Ah well. I did try…

It's grim out there

More depressing news from the High Street. According to the British Retail Consortium, shop prices rose at their highest rate for two and a half years in June. This is hardly an inducement to lure would be shoppers back into the stores.

And this follows a run of bad news with Habitat, TJ Hughes, Jane Norman and kitchen and bathroom company Homeform, all having gone into administration. The gravity of the High Street downturn is outlined further in new research published which shows UK retail chains closing stores this year at a rate of about 20 a day. The latest figures from PricewaterhouseCoopers show 375 retailers went bust in the second quarter of 2011, a 9% increase on the same period last year.

So how can we persuade customers to return to the high street?

The simple answer is we can’t, certainly not in the short term. Recent research from the Joseph Rowntree Foundation found that British families need to earn 20% more than they did a year ago to remain out of poverty as the squeeze on household budgets worsens. Any spare funds seem to be earmarked for cutting mortgage debt, as outlined by recent figures from the Bank of England. There is little money left over in the kitty.

It’s fair to say that weak consumer spending has devastated the high street and I fear there is more pain to come. Conditions will remain difficult for some time.