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Market views - UK Economy/Fixed Interest

UK ECONOMY/FIXED INTEREST

December 2009

Market levels (30 November 2009)

In this forecast we look ahead to the prospects for 2010.

The UK economy has been extremely weak over the past year. Gross Domestic Product (GDP) peaked in the first quarter of 2008 and has contracted in every quarter since then, for an overall fall of 5.9%. In the short term a sharp rebound is expected, in the run-up to Christmas. Many people have deferred big ticket purchases over the past year, and now that the economic outlook has started to stabilise there is significant pent-up demand. This will be encouraged by the prospect of VAT returning to 17.5% on 1st January, having been cut 13 months earlier. However, the factors that fuelled the economic boom - easy finance, confidence, big rises in government spending, strong global background - are no longer present, and so the recovery will be slow. We expect growth in 2010 to be around 1%.

While growth has been undershooting expectations, inflation has been doing the opposite. The headline rate on the Consumer Price Index (CPI) fell from a peak of 5.3% in September 2008 to 1.1% a year later. However, the fall was due to very poor figures from 2008 dropping out of the year-on-year comparison, assisted by the cut in VAT. When the VAT cut is reversed in January, the inflation rate will shoot up again, to well over 3%, where it will stay for most of 2010. This will be a headache for the MPC, whose inflation target is 1-3%, and will require Mervyn King to write another letter to the Chancellor. On the positive side, it means that the UK has so far avoided the greater threat of negative inflation, which some economists were predicting for 2009.

Turning to interest rates; the MPC has cut Bank Rate aggressively in response to the financial crisis, from 5% as recently as September 2008 to 0.5% in March. Although they will face some criticism when the inflation rate goes back above target, the greater concern is to see economic recovery, and the MPC will not raise interest rates until recovery is clearly in place. With only weak growth expected in 2010, interest rates may be kept at 0.5% throughout the year.

Finally gilts. UK policymakers are attempting to perform a complicated conjuring trick. In the long term people need to save more, as low saving helped to fuel the economic boom, but at the moment policymakers have interest rates at rock bottom to encourage spending. Similarly with the government’s budget deficit. The budget deficit is officially forecast to be £175bn over the coming fiscal year, 12.4% of GDP this fiscal year, with little contraction planned for the next. This is a very high level, and is largely due to rapid growth in spending over the last few years. Even in the boom the government ran a deficit when they might reasonably have been expected to run a surplus, and this pointed to a structural problem which has now been sharply exposed by the downturn. Not only is the deficit high, but the Bank of England has been buying gilts faster than the government has issued them, under the Quantitative Easing (QE) policy. This is now drawing to a close, and the markets face the difficult switch from the public sector being a net buyer of gilts to a very large issuer. It will be essential for the government and the Bank of England to maintain confidence in the British economy. If they fail, gilt yields will go up and the Pound will drop sharply.

Overall we hope and expect the authorities to continue to maintain confidence, with gilt yields to seeing just a moderate increase in 2010, in line with other markets as investors continue to move away from extreme risk aversion. The 10 year gilt yield is expected to rise to 4%, from 3.6% at the time of writing.

Page last updated December, 2009 ID1718