Weekly outlook

What the pre-budget report really means
 
By Tom Stevenson, 26 November 2008

Five investment take-aways from the Chancellor’s emergency statement  There is a good reason that Budget statements are made at 3.30 in the afternoon. The rush for pundits and journalists to make sense of a torrent of facts, figures and forecasts increases the chance that they will, in the short term at least, swallow whatever message the government is pushing. By the time a more objective picture emerges, the Treasury hopes, the picture of prudence or support for “hard-working families” or whatever this year’s message is will have been fixed.

"Bear markets end when shares no longer fall on bad news" Tom Stevenson

The consequence of the rush to assimilate a surfeit of information is that it can be hard for individuals to assess what, if any, the implications are for them. So here are five take-aways for investors:

1. The PBR was touted as the key to a shorter and shallower recession. Will it work? Impossible to judge because we will never know what the economy would have looked like in 2009 and beyond in the absence of the government’s £20bn stimulus. What seems likely is that the PBR’s boost to consumers’ real incomes and spending power will help avert a meltdown but is too late (and probably too little) to forestall a nasty recession. At the heart of the government’s proposed stimulus is a VAT cut that is far from certain to have much impact on spending. Saving £2.50 in every £117.50 is hardly likely to make or break a decision to buy a sofa and many every day costs, such as food, are exempt from VAT anyway. Also, people are not stupid. They see substantial extra taxes looming in three years time. How confident will that make them feel?
   
   
2. If confidence is the issue, how much can we take from the numbers outlined by the Chancellor? The short answer is very little. The fact that the government had to warn of significant tax increases, higher government borrowing and reduced public spending in the run up to an election is an indication of how bad Britain’s public finances have become. The gap between how much the government takes in tax and how much it spends is forecast to rise to 8% of national income. That is as bad as it has been in the worst downturns of recent years and it is notably dependent on the government’s forecasts for economic recovery, which as usual are more optimistic than most independent observers. The government’s books are not expected to balance until 2016, a forecast that is so far away as to be meaningless.
   
   
3. So there’s little to smile about on the tax and spend front. What about interest rates? Some good news here (unless you have cash on deposit) because interest rates now look likely to fall yet further. In theory, a stimulus to demand is inflationary but lower prices and the prospect of tax rises will have a larger, offsetting effect. The ongoing recession and falling inflation open the door to the Bank of England lowering rates again, some think to as low as 1% by the spring. Also, the scale of the proposed tax hikes in future years should ensure that interest rates are kept relatively low for years to come to stimulate demand.
   
   
4. Which investments will benefit in this environment? Falling interest rates are good for bonds because investors will accept lower yields from safe havens like government securities and are prepared to pay more for the fixed income they offer. There’s no simple formula, however, because worries about the health of Britain’s public finances will tend to drive yields higher and bond prices lower. So too will a mismatch between the supply of gilts – an all-time record £146.4bn is due to be issued this year – and investor demand. The value of corporate bonds, historically cheap as they are, is dependent on the length and depth of the recession. More company failures means investors demand higher income in return. As for equities, lower interest rates are good for the market as a whole, but with the same caveat. An extended recession and less spending power in the future because of higher taxes will keep a lid on the earnings which in the long-run drive share prices. The question is how much of this bad news is already priced into the stock market. Answer: probably quite a lot, but sentiment remains fragile.
   
   
5. As an investor, even one based in Britain, do I really care about the health of the British economy? Good point. A high proportion of the earnings of Britain’s biggest companies are made outside the UK. That means the state of our economy and national finances is less important than in earlier years. However, as the Chancellor was at pains to stress in his pre-budget speech, the downturn is not “Made in Britain” but a global retrenchment of an increasingly interdependent global economy. Wherever you look around the world, there’s pain still to be felt. One of the most interesting aspects of the pre-budget speech, however, was that, despite all the bad news, the FTSE 100 recorded its biggest-ever one day rise within minutes of the Chancellor sitting down. For investors who believe that the bear market can only end when shares no longer fall on bad news, the market’s reaction to the PBR said it all. The end is in sight.