Investment Management Blog - Montague Capital

Just when it seemed that the government’s reputation for sound economic management couldn’t get any worse, its reputation has received another killer blow with reports that the Treasury is considering relaxing the “golden rule” on borrowing in order to make ends meet.  Slower economic growth means that tax revenues are insufficient to fund planned spending.  If the government won’t cut spending (i.e. sack the public sector workers whose unions fund it) or risk losing even more votes that it is going to already by raising taxes (which is completely inappropriate in a Keynesian sense going into a recession anyway), then it has no option but to borrow more.  The 40% of GDP borrowing limit is meant to apply over the “duration” of the cycle, so the Treasury plans, quite simply, to declare the current cycle over this autumn and to start the meter again.  This is the sort of spin which even Labour sympathisers have come to loathe.  There is no more reason to believe that the economy will grow fast enough over the next cycle (however long that is) so as to “permit” this increase in debt, than there is for thinking that house prices go up for ever so as to support unaffordable consumption.  Honesty is what is required here.  The Treasury has already decided that the bail-out of Northern Rock doesn’t count here, in much the same way as food and energy are somehow “non-core” parts of the inflation basket.  If this, or frankly any other government, ducks the tax/spend choice, then borrowing has to rise.  And as it does it puts upward pressure on interest rates, as the government competes for funds, which may be good for the fight on inflation but which crowds out the investment and consumption the economy needs to recover. 

Wall Street’s quarterly result season is making it a little challenging to believe in the proposition that earnings are recovering in US Inc.  Merrill Lynch decided not to spoil what was a good day for the Dow by withholding its results until after the market closed.  And with good reason.  CY08Q2 write-downs were much bigger than expected at US$9.4bn, making a total of US$19bn for the last year.  Nor is that likely to be the end of the rot.  Merrill’s CEO said, “We continue to be in a difficult period.  House prices are still falling.  You have rising energy prices, rising food prices and rising unemployment.  All those are going to drag on the economy and that’s not good for business or for asset prices.”  Don’t expect to see the shares maintain yesterday’s 8% rise today.  Merrill managed to offset some of the write-downs by getting US$4.4bn for its stake in Bloomberg, but that fell short of the US$6bn it was hoping for.  Nor can it find a buyer for its 49% stake in BlackRock, worth perhaps US$5bn, not because the latter is doing badly (it isn’t) buy because the buyers know Merrill is a forced seller.  If we’re still worried that Fannie and Freddie need emergency treatment in order to avoid failure, then we’ve not had the end of bad news like Merrill’s yet.  Both BlackRock and JP Morgan Chase, which also reported yesterday, gave downbeat assessments of the direction of the US economy. 

Things were also disappointing in supposedly recession-resistant tech stocks, both Google and Microsoft failing to meet market expectations and seeing their shares fall 6% and 8% respectively.  These are both companies that make much of their “global reach” and reduced reliance upon whether US Inc. is now heading over the edge of a cliff.  Unfortunately, with emerging economies now encountering problems of their own, that “global reach” may not be such a “get out of jail free” card after all. 

The IMF has revised up its forecast for global economic growth from April’s initial 3.7% to 4.1%.  Its forecast for the UK has been raised from 1.6% to 1.8% this year and from 1.6% to 1.7% for 2009.  (HMG is still expecting 2.0% and 2.5% respectively, but then it is taking some serious drugs.)  It is a pleasant change to see growth forecasts moving up rather than down, but the IMF still places important qualifications on its relative optimism.  It states that “The top priority for policymakers is to head off rising inflationary pressure, while keeping sight of risks to growth.”  Next, its expectation for a slower rate of decline for global growth still has to be reconciled with its forecasts that US Inc. will “contract moderately during the second half of the year” as the (limited) effects of this year’s tax rebates wear off.  Finally, the IMF does not make explicit the transmission mechanism whereby oil, commodity and food prices will obligingly level off/fall such that inflation drops out of the system without the need for recession-inducing tightening of monetary policy. 

Centrica is doing its bit to help the Bank of England keep inflation expectations down – not.  A report it commissioned into the likely future direction of the European gas market concluded that gas prices could rise 60% over the next three to five years.  So that “could” is really “will” then.  It’s only a matter of time before Centrica uses this “independent” report as “evidence” justifying its decison to raise prices.  The difficult question is whether this 60% (or 70% by the time it hit this morning’s breakfast TV programmes) includes the tariff increases we have already been warned to expect by the end of this year, or whether it is in addition to them.  Either way this is another twist to the inflationary spiral we could really do without.  If we want to see the energy component of our spiralling household bills fall, then we had better start doing something serious about renewable energy sources very soon.  Otherwise it’s time to get the woolly jumpers out of mothballs, to start learning how to make candles and to train the family pet to run a treadmill to power the telly.