Economic Newsletter dated December 2007

At the beginning of September I attended a meeting of Wiltshire Council Pension Fund where, prior to Northern Rock, I suggested the possibility of a UK institution effectively becoming ‘insolvent’. At the time it was very difficult to get any support for this view. However, I was not to realise that it would happen literally a couple of weeks later!

Economic Outlook

For two years at our seminars, we have been highlighting the risk to our economy of government overspending during a boom and of the inevitable downturn of property. Whilst we were concerned about debt we could not have anticipated the ‘credit crunch’. Some of the sensationalistic headlines in the media could be an over-reaction to what, in many ways, was inevitable. There had to be a correction and an economic turn in UK PLC at some point, and the ‘credit crunch’ is not the cause of that, but is certainly an accelerant or catalyst. Ultimately, I must highlight that AisaProfessional believes in spreading your risk amongst several assets and asset classes. As in September, we advise people not to lose out by risking all their money in one class or area! Your aim should always be maximum return for appropriate minimum risk.

The views in this letter represent the opinions of Aisa and should not be construed as a statement of fact. Further advice should be sought before actioning any investment or tax advice. The Financial Services Authority does not regulate opinions on the economic outlook, nor does it regulate some forms of tax advice or comment.

Further to my letter of the 21st September, to some clients, regarding the turmoil in the markets at that time, I thought it appropriate for a year end update. In September I wrote, “The Government has just guaranteed 100% of existing Northern Rock savings accounts. This can clearly send out the wrong message as “Why would anyone buy government backed gilts or savings with their much lower rate, when Northern Rock has higher rates and existing savers now have the same government security?” This is clearly untenable…..”. Surely the reason why rates rise, and in particular some institutions have to pay larger rates to savers than others is a ‘risk premium.’
We now discover that due to European Rules the government cannot continue with this strategy beyond March 2008 without re-applying for approval, and in the meantime lending has gone up to the equivalent of the annual Defence Budget.

On the 30th November we were told that the Council of Mortgage Lenders (CML) warned that “funding pressures have started to crystallize for a number of lenders" and they were issuing a plea to the Bank of England (BoE) to reduce rates.

What economists are concerned about is that we already have a budget deficit, high taxes and high spending. A more prudent stewardship of UK PLC should have a nil or neutral budget deficit. Additionally, we have inflation feeding through which means that interest rates should be moving higher. The UK picture is not good in our opinion with very little room for manoeuvre either for the government or the BoE. Despite this the BoE were somewhat forced to cut rates on 6th December, because they had to deal with the near term problem of growth dwindling and possible stagflation; they also now have to deal with the issue of ‘expectation’ and confidence in the market. All of these outweighed the other main issue of inflation, which could still cause problems of its own with a weaker pound making imports like oil (petrol) even more expensive! However, it could also allow exports to increase, which may just keep the economy out of major trouble.

Certainly, the government is either going to have to increase taxes or reduce spending in the next two years, or our budget deficit is going to get out of control. The real problem right now is the perceived management of UK PLC and the lack of liquidity around the world, which has kept LIBOR rates extremely high as a percentage above base rate in the UK.

As I wrote in September the global economic pressures that are stemming from the credit squeeze are affecting all of the four main asset groups. Thus, Equities, Property, Fixed interest and Cash, are all being affected. The liquidity problems, highlighted in the Northern Rock crisis are not over and clearly the CML feels there is a risk that leads to other institutions needing to increase liquidity.

Finally, in the US they are experiencing a weak dollar due to their budget deficit. Those countries ‘pegged’ to the Dollar are suffering increased inflation as a result, although this, interestingly, leads to growth in the US economy at the expense of others. The problem is not isolated to the UK or the USA.

Equities

I advised in September there would be further turmoil ahead after the UK stock market bounced from its lows on the 19^th August by almost 500 points, to 6461 on Friday 21^st Sep. It has continued to gyrate considerably as information continues to drip through, and we continue to forecast an elongated rocky patch. As we always have to say at this point, past performance is not a guide to future performance and your investment can go down as well as up. We retain the position that rising inflation in China is a concern; as is consumer confidence in the USA and these two factors need to be monitored.

Remaining invested in equities with a long term view is still the correct position. Diversification across markets, sectors and worldwide shares is a must. We have sympathy with those that invested around the February to July period this year that are possibly seeing a loss, but this is on the tail of a very good rally over the last few years. Most long term investors are still better off; in some cases much better off, than when they originally invested over, say, a 10 year period.  

Cash

In September I wrote, “Almost certainly we have reached the peak of the current interest rate cycle as a result of the credit crisis. However, as people have finally noticed, the actual rate at which cash is distributed and lent between institutions is actually the LIBOR in the case of the UK.”

Over the last 2 weeks we have seen a second peak increase in LIBOR (The first being in September) well in excess of 0.75% over the actual interest rate. The equivalent inter bank lending rates in the USA and Europe are also higher than their interest rates. To an extent, until this reduces, the tough money market conditions will continue, even if the BoE reduces headline rates. Building Societies have to get cash, which means they have to raise savings rates to attract customers, or borrow at higher rates. The higher rates are also a risk premium for those institutions not doing so well. Fundamentally, cash is good if you are a saver at the moment (not allowing for personal taxation which can take up to 40% off the return) but it is not so good if you are a borrower, e.g. a variable rate mortgage holder.

Property

In September there was still confidence in the market – amazing how less than 3 months can change everything. However, I wrote at the time:

The nail in the coffin for UK property would be one or more of four things:

1. Lenders making it more difficult to borrow, or restricting loans to good ‘bets’
2. Unemployment rising, and thereby consumer sentiment changing.
3. The Buy to Let bubble bursting if people cannot make money in the short term.
4. Increasing mortgage payments as fixed rates end over the coming 9 months

I expected the answers to these questions to take many months to feed through, but here we are in December with a few of the answers:

1. Lenders are making it more difficult to borrow, and are restricting loans to good ‘bets’, whilst decreasing Loan to Value (LTV) percentages - and they have turned to being conservative on property valuations
2. The one I least expected to happen was (2). However, whilst unemployment is unchanged the fact remains that consumer sentiment is changing. On the Times website a typical comment is “Houses of all kinds were vastly overvalued by any measure, and simply driven by expectations of further increases”.
3. Fundamentally, ‘Buy to Let’ only works if you have a good level of equity in the property, or a rental income is in excess of debt and maintenance payments, or finally, rising house prices. For too long rising house values have hidden the other fundamentals. So, by projecting 2 or more years of house price stagnation then the only profit investors can make is net cashflow. In too many cases this figure is actually a minus! Let us hope that they have a risk plan in place.
4. It is increasingly reported that people are struggling with increased mortgage payments. However, there has been a further issue added, which is due to the continued issue of illiquidity; it is now actually slower and more problematic to re-mortgage. There are stricter criteria, including LTV equations that are going to leave some people isolated on much higher repayments.

I question those voices arguing stagnation of 0% in the coming year. As an example, if a property was worth £100,000, then indices during the last 3 months show it to be worth at least 2% less on a conservative basis, or £98,000. Therefore, that property would need to grow in excess of 2% over the coming 9 months to remain neutral over a one year period (3 months have already gone). If one allows for 3% inflation as well, the property would have to grow by around 5%. Does anyone believe this will happen? The average city hedge fund is forecasting a 7% drop in house prices (or 10% in real terms!). A double digit annual decrease was not even experienced in the two previous housing ‘crashes’.

Fixed Interest

Better rated investment grade bonds look more attractive, having already suffered significant capital losses over the last 12-24 months. This has occurred through the combined effect of rising government bond yields and, more recently, widening credit spreads.

Conclusion

We are in a volatile economic situation that we expect to last another twelve to eighteen months at least yet, with all the asset classes being affected, from cash to equities. To combat this volatility, spreading your assets is the proven way to work.

Ultimately many of you have already committed to our way of thinking. Now is the time to re-enforce that with a balanced portfolio, that holds all the main asset classes. We think those of you purely in Equities or Property at the moment are going to suffer increased volatility, possible high risks, and you need to speak with us now.

Remember that we combine our advice with the latest in tax planning, to prevent you losing more money to the taxman than you should.

AisaProfessional advisers; providing high quality advice to benefit you!

Please note that the opinions expressed in this letter must not be construed as statements of fact – you should carry out your own further research before coming to a decision and before taking any action.

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