By Allister Heath and Bill Jamieson.
In Shakespeare’s play, a hallucinating Macbeth has a vision of a dagger, pointing toward the King’s chamber, urging him to follow through on his dark plans to murder Duncan, the sleeping Scottish monarch.
For Gordon Brown, Britain’s Scottish Prime Minister, there can be no worse nightmare than the prospect of the UK sliding into its first recession in over 15 years. The Prime Minister must feel like being Duncan, with a massive dagger pointing at his chest, ready to puncture what is left of his much-vaunted reputation for economic competence.
Over the past month prospects for the British economy have darkened, even if they are still some way from Macbeth-like gloom. Plunging figures on mortgage lending, faltering house prices, falling business confidence, declining retail spending and, above all, persistent worries over the damage to the financial system from the continuing credit crunch – taken together they have caused some to warn of a 1991-92 style recession.
Others have gone even further, arguing that with the intensifying crisis in money and credit markets it could prove to be much, much worse. Even though the consensus among forecasters is still for growth of 1.9% next year (down sharply from 3% this year) it is the rising volume of gloomy assessments that give rise to fears that Britain could talk itself over the precipice of a sharp slowdown and into full scale recession.
Luckily for Brown and the economy, the ultra-bearish economists are likely wrong. The American downturn is being cushioned by globalisation and the boom in China and India, while the economy and car drivers have learnt to cope with oil at $100. Sterling has slumped by almost 7% against the euro over the past two months, helping exporters and partly cushioning the British economy against the weak dollar.
But, even though the economy will continue to grow, the slowdown will be painful. The weakest year of growth since the current 15-year cycle began in 1992, when Britain was mercifully booted out of the Exchange Rate Mechanism, was 2005, when the economy grew by only 1.8%. Five leading forecasters – including ING, Lehman Brothers and Lombard Street Research – are already warning that next year will be worse than that.
Some institutions, such as Citi, which is pencilling growth of 1.9% next year, believe it will be almost as bad. Perhaps most worrying of all, the Bank of England expects growth to drop to around 2%, even assuming that interest rates fall from their current 5.75% to 5.25% by the middle of next year.
There is every reason to be apprehensive. The American sub-prime mortgage collapse and the mayhem it triggered through financial markets have turned out to be far greater than first thought. Leading American and European banks now face bad debt write-offs estimated to total between $200bn and $500bn.
This is a colossal hit on the financial system, one that is already triggering closures and redundancies across the sector. This week we learnt that HSBC, Europe’s biggest bank, has been forced to step in to support its two structured investment vehicles with funding of up to $35bn to prevent forced asset sales. Citi, America’s leading bank by assets and with a big presence in Britain, said this week that it is planning major job cuts over the coming months; Abu Dhabi is giving it a helping hand with a capital injection.
British banks such as Barclays and Royal Bank of Scotland have seen billions of pounds wiped off their share values over bad debt concerns. But despite all of this, the global financial architecture is remarkably robust; while devastating to their bottom lines, the big banks will withstand the onslaught.
More worrying is the prospect of banks sharply curtailing their lending both to business customers and households. Already lending for house purchase and remortgaging has fallen dramatically in Britain: mortgage approvals by number have tumbled to just 44,105 in October compared with 70,458 a year ago. The severity of the slide in mortgage approvals is, says Citigroup economist Michael Saunders, “stunning” and the clear implication, he says, is that “housing demand is in freefall”.
The “hope” of course, is that central banks both here and in America, cut interest rates. But they are reluctant to do so for fear that knock-on effects from dearer oil and foodstuffs will push up inflation. The dilemma for the Bank of England’s Monetary Policy Committee is acute; it already looks as if the MPC is condemned to a policy of “too little, too late” as the economy starts to slow.
Survey evidence by YouGov points to a further rise in inflation expectations; and those for the year ahead are the highest since the survey began two years ago. This, says Saunders, “will probably ensure that the MPC do not cut quickly enough to avert a major economic slowdown in 2008”.
What might cause even rate “hawks”, such as The Business, to put slowdown concerns ahead of worries about inflation? Just this: if there is a sense that the government has lost control of the economy, this of itself would encourage caution and retrenchment by consumers.
It is not hard to see how such a perception could start to change consumer behaviour: the run on Northern Rock; the fiasco of the lost discs containing personal data on 25m British households; tales of falling prices and “stuck” property on the market with no offers; and continuing gloomy headlines in the newspapers. All this may cause many to downgrade their expectations, cut back on their spending and build their cash savings.
Even without the inflation constraint, the deeper worry is that confidence will not respond as expected to rate cuts and that banks will still be reluctant to lend to each other, keeping up rates in wholesale markets. Three month sterling Libor – the London interbank offered rate which is the main setter of interest in the London wholesale money market – has risen by between 0.2 and 0.25 percentage points since early November to about 6.5%.
This is the highest since mid-September, despite widespread expectations of lower Bank interest rates; 60% of business borrowing linked to Libor rather than bank rates. As the financial crisis persists and widens, the fallout will be felt in reduced credit availability and higher borrowing costs for companies and households; both could escalate quite markedly. In such circumstances, until confidence returns, a quarter point cut in interest rates is unlikely to have much effect.
In the commercial property and housing sectors, a contraction now looks unavoidable. Leading commercial property funds have either cut prices or are seeking to delay investor encashment as the market deteriorates. In housing, activity and prices are increasingly faltering in the face of tightening lending practices. Sharp falls in house prices could become widespread if both sellers and buyers expect a sustained fall: the self-fulfilling dynamic that can turn a correction into a rout. The City is betting on British house prices falling by 7% next year in new tradeable derivatives contracts.
Could the housing recession spread across the whole economy? House purchases themselves have been a trigger point for more consumer spending as successful purchasers adapt the property to their own tastes and requirements. Furniture and DIY retailers have flourished in times of high housing turnover as interiors – barely a few years old – are ripped out and replaced. Mortgage equity withdrawals – frequently associated with buoyant spending in the high street – have also fallen sharply.
In the business sector the concern is that companies mothball or cancel investment and expansion plans and adopt a “hedgehog” defence by cutting costs in the face of falling orders. Real though these prospects are, we are not there yet.
The November report of the Bank of England’s regional agents included a survey of the effects that tighter credit conditions were having on companies. The agents spoke to 900 companies in compiling their findings. The majority reported few direct effects so far. Either they had already secured finance for their business plans or were using internally-generated funds to invest. Many said banks were lending actively where the loan transaction risks were straightforward to assess.
But a minority of companies warned that tighter conditions were affecting their operations – highly leveraged firms seeking to refinance, businesses seeking syndicated finance or small- to medium-sized firms with reduced access to trade credit. Financial services and property firms seemed especially hard hit, with a reduced demand for accountants and corporate lawyers.
Overall, however, the effect of the “crunch” on corporate investment decisions appears to be small for now. Companies seemed to be delaying their spending commitments rather than cancelling them as they waited for the turmoil in credit markets to settle.
Employment, though a lagging indicator, continues to hold up well, though most new jobs are going to better skilled and motivated immigrants. Job cuts in the City have yet to reach unbearable levels; this could easily change in the New Year. Deals are still being done and expansion plans going through.
Retail sales slipped by 0.1% last month, their first drop since January, though they are still up significantly over the past year. Much attention will be paid to pre-Christmas shopping behaviour. Early indications are that this has not fallen off a cliff. This could mean that consumers are shrugging off the bad news headlines, or deciding to defer the spending hair shirt until the New Year. For many households, Christmas spending is not seen as a luxury but an obligation. January will prove a better indicator of where the trend is going.
What should be the response? The first should come from the Bank of England: the sooner it cuts interest rates, the less the risk of the downturn turning into full blown recession. The second should come from Alistair Darling, the Chancellor, and Brown, who still really controls the Treasury.
Despite stronger-than-expected economic growth in the first six months of the current fiscal year, government revenues are lower than forecast and spending is running above forecast. Public sector net borrowing so far this financial year has hit £24.2bn, a massive £6.7bn higher than in the same period of 2006/07. Richard Jeffrey, chief economist at Ingenious Securities, is already forecasting that the overall deficit will hit £50bn in 2008-09, a devastating sum.
Darling needs to get a grip, particularly in those well-publicised areas of public sector waste. The proposed capital gains tax change should be scrapped as it has caused many small businesses to consider selling up before next spring: a forced exodus at the worst possible time. The attack on non-doms is also misplaced; it is the worst possible time to be chasing away highly-skilled bankers and investors. Business rates must be reduced quickly, corporation tax cuts and regulatory barriers to growth hacked back.
Even if Brown continues on his current, misguided course of action, Britain is unlikely to undergo a recession next year. That won’t be enough to salvage the Prime Minister’s reputation, however; weak growth will be painful for consumers that have grown used to never ending good times.
In the final scene of Shakespeare’s play, Malcolm, one of Duncan’s sons, is crowned as the rightful king – and Macbeth, now widely seen as a useless tyrant, is beheaded. Whatever the denouement this time around, at least Brown knows he will get away lightly in comparison.
