Jam tomorrow?

While economic woes appear to be getting deeper as 2009 wears on, how will school investments fare? John Kelly reads the long-term signals and assesses the impact of the recession on the UK and global economies

The current downturn in the economy has surprised observers by its speed and severity. Since the end of the third quarter of 2008, output levels have simply plunged and although forecasts have been reduced in an attempt to keep pace with the new reality, these changes have been late, reacting to events rather than anticipating them.

It is now clear that the current downturn is not a conventional recession. Usually, a period of declining growth is triggered by a rise in interest rates, justified by signs of economic overheating and building inflationary pressures. Credit remains available, but at a higher price and so it is the cost of borrowing that acts as the brake on activity. The current position is quite different. There is no rationing by price: interest rates are at their lowest levels for more than two hundred years.

Instead the problem is one of availability, as the credit crunch, collapse of bank balance sheets and the withdrawal from the market of a number of secondary lenders combine to reduce the ability of companies and individuals to borrow. Furthermore, the mechanism by which the funding is made available is unclear, with the result that there are desperate shortages of funding in some areas regardless of the credit rating of the borrower. This has introduced an increased level of risk in the economy and has clearly influenced corporate behaviour. It is, for example, a prime factor in moves to cut costs and reduce headcount – unemployment is rising at a rate not experienced for nearly forty years.

Industrial production fell by 4 per cent in the final quarter of 2008 and by another 2.5 per cent in January. This pace of reduction is similar to that experienced in the severe recession of the early 1980s – from which output took five years to recover fully. The decline is consistent, with an overall fall in economic activity over the year of about 3.7 per cent. If the low point is reached in the third quarter of 2009, then the peak to trough fall will be around 5 per cent: a severe setback indeed.

Cutting back
This is an environment in which organisations will continue to cut inventories, adding to the pressure on manufacturers. Unemployment will continue to rise and, having broken two million already in the cycle, could reach three million before conditions improve again. Clearly, corporate profits will be under severe pressure and, despite the exposure of many large companies to profit sources overseas, where activity levels may be stronger and where returns will be helped by translation back into a weakened sterling, expectations are for a fall over the year of between 25 per cent and 30 per cent.

This will put great strain on dividend payments. Already a third of the companies in the FTSE 100 Index of large companies listed on the London Stock Exchange have indicated reduced payments this year and this number is likely to grow in the months ahead. Short-term interest rates will remain low. Investors expect no increase in base rate in 2009 or into 2010.

A weak recovery – which is more likely than not – will see low borrowing costs remain through the first half of next year and possibly beyond. Inflation will also be low. CPI measures of the pace of price growth will hug zero in the second half of the year. RPI measures, which have already retreated to below 1 per cent, will move into negative territory.

A background of minimal or negative inflation, higher unemployment and general economic woe suggests that wage freezes and pay cuts are likely to feature increasingly in annual wage negotiations. The Government, of course, has committed to spending vast sums to prop up a broken banking system and to support economic activity. The fall in tax revenues and the need to spend more to help the unemployed will leave its financial position horribly stretched. The financial sector contributed 27 per cent of tax receipts last year but the contribution will be much lower in 2009 and for years ahead. The reduction in VAT will be reversed in 2010 and personal tax rates will increase, but pressure will grow on Government spending, with cuts to capital and revenue programmes to be expected. The squeeze will permeate quickly through to local government, which remains heavily dependent on central funding.

Under pressure
2009 is set to be a year where all aspects and areas of the economy remain under severe pressure: the economic clouds are likely to remain in the early part of 2010.

Beyond that, however, there is an expectation that some improvement will be seen, such that next year as a whole should see a modest rise in output. To be clear, all the indications are that growth will be relatively insipid and back-end loaded into the second half of the period. It will be based on the cumulative contribution from several factors, which together should be sufficient to reverse the downswing and add positive momentum to output, albeit over time.

Some of the factors will be passive. These include the knock-on effects from growth in economies overseas, where performance is likely to be stronger than in the domestic market. At the moment, the run-down in inventories is contributing about half of the overall reduction in output. In time, however, the adjustment process will draw to a close and, when that happens, an important source of downward pressure on activity will ease.

Other factors that will help growth include the benefit from a weaker currency. The fall in the pound will improve the terms of trade for UK goods in international markets. Obviously, export market shares do not grow overnight, particularly when the global economy is in recession. Over time, however, a 27 per cent fall in the trade-weighted exchange rate will increase the relative attractiveness of UK-produced goods.

Low interest rates will stimulate personal disposable income because of the effect on the mortgage market. UK homeowners spent about £100 billion in 2008 on mortgage interest payments and this sum will fall as lower interest rates are reflected in mortgage costs. So far, the average rate has fallen from 5.75 per cent to 4.25 per cent and there are more falls to come. During this year, average mortgage payments will decline by about £140 per month and while initially much of this may be saved, in time it will help support consumer expenditure. On a cumulative basis across the economy as a whole, the potential stimulus from this source is larger than that from the cut in VAT.

Better times ahead?
There are signs that the Government’s efforts to resuscitate the banking system is having some effect on lending, while the quantitative easing measures recently undertaken by the Bank of England have lowered long-term interest rates. Easier availability and a lower cost of funds will be an important part of rebuilding industrial confidence and supporting strained corporate profit and loss accounts.

On balance, therefore, the consensus expectation is that a recovery will get under way in 2010, but there remain risks. The two most significant are that there are as yet fresh casualties to emerge from the collapse of the financial sector or that the vast increase in public spending triggers a surge in inflation that coincides with the increase in global demand that the recovery will bring.

John Kelly is head of client investment at CCLA.

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