venerdì 31 luglio 2009

What future for UK economy ?

“Sell any sterling you might have. It's finished. I hate to say it, but I would not put any money in the UK". This was investment guru Jim Rogers’s suggestion last January, which stirred up anger and poignant comments by many UK investors and commentators. Even though the unfortunately unheeded advice of the co-founder and former partner of the Quantum fund might have been exaggerated to surprise the international audience, the events of the subsequent months have confirmed that the health of the UK economy is deteriorating sharply. Since January 20 (the day of Mr Rogers statement), the pound has gained 6% against the euro and almost 18% against the US Dollar. However, Q2 GDP data released last week showed that the negative pieces of news for the UK economy are far from over. Indeed second-quarter GDP eased by 0.8% q/q, more than twice the consensus estimates, while the y/y decline was 5.6%.

But last week’s UK GDP drop is likely to be the latest of five consecutive declines since Q2 08. Some economists, including Michael Saunders of Citigroup, expect a return to growth in the current quarter. A rather widespread consensus is for UK GDP to be back in positive territory in Q4 09 at the latest. Nevertheless, the UK economy will likely remain sluggish in coming quarters, with almost no chance of a V-shaped recovery. A recent study by Deloitte has reinforced these fears, predicting GDP growth of just 0.5% in 2010 and 1.5% in 2011. Not only will a below-forecast economic improvement affect employment (Deloitte sees the number of unemployed exceeding 3m), but also the public accounts. Indeed, the Treasury relies on 3.5% growth in 2011 to restore health to the public finances. But worse than expected public accounts may surface well before 2011. For example, the Treasury’s estimate of a 175bn pound deficit in 2009 is based on the assumption of a 3.75%, contraction, which is more optimistic than the predictions of both the OECD (-4.3%) and IMF (-4.2%).

Persistent concerns on the health of the public finances are weighing on the UK bond market. The 10-year government bond yield now stands at 3.97%, well above that of the US (3.74%) and Germany (3.48%). However, expectations of a higher inflation in the UK than in the US and Euro zone should drive yields higher. Average inflation expectations over the next 10 years are at 2.36% in the UK, 1.88% in the US and 1.77% in Germany. The high public debt and the devaluation of the pound over the past two years (the Euro/Sterling exchange rate rose from 0.67 to 0.86 in August 2007 and neared 1 at the end of 2008) are the reasons why economists are predicting a more elevated inflation rate in the UK.

These expectations have led most economists to believe that the Bank of England will be the first Central Bank to raise rates and to conclude this phase of ultra-expansionary monetary policy. The outcome of the Executive Committee meeting, scheduled on August 6, will undoubtedly shed light on the issue. Whether the asset purchase program will be expanded upon having reached the threshold of 125bn pounds established at the outset will dominate the meeting’s agenda (no rate movement is expected).

But crucial indications of the inflation outlook will likely be offered by Bank of England Governor Mervin King’s quarterly press conference on August 12, on the sidelines of the presentation of the Inflation report. Any statement by Governor King (who traditionally anticipates the actions subsequently taken by other central banks) on the implementation of an exit strategy may clear the way for other international central banks in the months ahead. By contrast, lack of guidance for the inflation outlook would be a clear sign that the UK is still a very long way from getting back to normality.

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