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16 January 2008
Business and Economy

Overview

The UK economy has experienced a number of significant negative effects during the period from the summer of 2007 through the turn of the year. From the global credit crisis to Northern Rock, interest rate reductions but higher borrowing costs and now a dramatic fall in sterling and the stock market. So what does this all mean for me?

Anatole Kaletsky's report in the Times of 3 rd December 2007 (see below) suggests a positive future scenario for the US , despite the US housing crisis, at the expense of Europe and the UK . Whether he is right or wrong how do we see the future in the UK for interest rates, sterling and the stock market?

Even the most uninformed have known that something negative had been building up in the UK economy for a considerable time. Credit had been fairly easy to obtain, house prices continued their upward spiral and employment prospects and prices have been fairly good. However, since the summer of 2007 this has all changed and quite dramatically so.

Without going into a detailed analysis of the underlying reasons for the conditions that existed before and after this change where do we think this is all heading for UK consumers and businesses?

Interest rates

The general consensus is that UK rates are heading downwards and we have already seen the first of these during the last quarter of 2007. This was partly in response to the credit crisis and the cost of credit in the wholesale money markets as interbank lending dried up but also as an aid to the slowing of activity in the UK economy. It is likely that this trend will continue as growth continues to be weak and exports suffer as sterling remains overvalued against the dollar and other major currencies.

The only possible opposing scenario is that there are upward inflationary pressures circulating in the UK economy particularly from energy suppliers and of course the price of oil which impacts across many sectors. The government use interest rates to control inflation and if it shows signs of heading upwards interest rates could well rise although the current consensus is that this is unlikely.

What can businesses do?

Although the price of money has increased as supply has diminished the lending institutions still have to maintain their own profits and there will be much competition to provide new and refinance existing credit lines.

Talk to your lender and keep them informed Update your forecasts and cash flows to know where you are going and keep your bank onside. If you have pressure you're your lender you will have the information to support your borrowing requests.

For the more sophisticated you can hedge against interest rate movements and maintain control over your profit stream.

It has not been possible to go through all the details supporting the issues brought out in the commentary above and if you would require further advice on this topic please contact Charles Wiggin in our Corporate Finance Department on Charles@accountingservicesonline.net or call 0207 636 2430.

Currency

Sterling has appreciated significantly against the dollar and weakened against the Euro its main traded currencies. There has been a general appreciation against other main currencies but that is more a function of cross rate devaluation in the dollar.

The volume of currency traded daily on the currency markets dwarfs the volume attached to trade related activity as speculators trade using ever more sophisticated products and financial models to profit from movements in the currency markets whether driven by cross border trade or speculation.

Sterling has recently started to depreciate and it is likely that it will fall further against the dollar (as the dollar rises) and also against the Euro, although there are signs that the Euro has come to the end of its bull run. This will be good for exporters but increase the cost of imports which could put upward pressure on input prices.

What can businesses do?

Currency swings are more volatile, more unpredictable and can be significantly larger than interest rate movements. If you are trading in a currency other than your home currency you need to have a system in place for ensuring that once a deal is done, either with a customer or supplier you cover the currency exposure that exists from the point of sale.

It is possible to hedge currency by setting up forward currency contracts in order to fix the exchange rate of the currency that you wish protect. In addition, if you are trading on a regular basis with currencies other than your home currency you will need to correctly account for the currency transaction and monitor your exposure to foreign currencies in general both to cover exposure on current deals and to develop the more long term policies that support your foreign trading activity.

If you require further advice on this topic please contact Charles Wiggin in our Corporate Finance Department on Charles@accountingservicesonline.net or call 0207 636 2430.

Housing

House price inflation has eased and there is talk of no or negative growth in some regions over the foreseeable future. Immediately this impacts on the supply of houses on the market and may mean if you have to move this could increase the prices of properties as demand exceeds supply for a lower housing stock. Coupled with this situation lenders are now demanding larger deposits and levying higher interest charges as the sources of funds to themselves have become more expensive as increased risk is priced in by the wholesale credit markets.

Many low fixed rate deals have finished only to be replaced by significantly more expensive fixed or variable rate mortgages.

What can you do?

As a consumer if you are under pressure to maintain your mortgage payments and you cannot downsize to relieve some of the pressure on your finances you must as a minimum talk to your lender as financial pressures lead to all sorts of other problems domestically. You may well obtain some relaxation in your monthly payments if you have a repayment mortgage or remortgage with another lender. As with the example of borrowing costs to businesses highlighted above there will still be deals done although they will be more difficult to obtain post the global credit crisis.

If you require further advice on this topic please contact Charles Wiggin on Charles@accountingservicesonline.net or call 0207 636 2430.

Anatole Kaletsky's report in the Times of 3rd December 2007

What has been this year's most important economic and financial story? Most people seem to agree that it has been the global credit crunch and the US housing crisis. However, in fact, this has been a sideshow compared with the far more important shift in the structure of global growth in favour of America , largely at the expense of Europe, including Britain . This shift was confirmed by the remarkably strong US GDP figures published last Thursday and is likely to trigger a substantial rebound in the dollar - just when cover stories in business magazines around the world are announcing the American currency's permanent decline.

While the markets and the media have focused on the risks of a US recession, the third-quarter GDP figures actually showed an acceleration of growth to 4.9 per cent - the strongest quarterly growth rate since the first year of the present expansion in 2003 .

However, the good news that America has kept growing rapidly despite the collapse of housing is tempered by some very bad news: the biggest casualties of the falling dollar and the crisis in the US property market will not be American homeowners and consumers, but businesses and workers in the rest of the world.

This is because the driving force of the US economy's acceleration this year has an upsurge in net exports - and this trend is likely to become even more pronounced in the near future, for reasons directly related to the property slump.

A strong link has been observed over the years in most advanced economies between housing cycles and the balance of payments. When property prices boom, a country's imports tend to rise and its exports to slow down, as market forces shift labour and resources from manufacturing to housebuilding and consumption. Once house prices start to decline, the opposite effect occurs and the trade balance shifts in favour of exports. ( This relationship was clearly demonstrated by the detailed study of 44 housing cycles in 18 countries published two years ago by the Federal Reserve Board ).

The experience of all these cycles suggests that, as house prices decline, the US will probably reverse most of the deterioration in its current account deficit over the past four years. This deficit increased by 3.5 per cent of GDP, equivalent to $400 billion, between 2002 and 2005. Thus a narrowing of the same amount - say $200 billion in each of the next two years - should now be expected.

A year ago, such a prediction might have seemed just a theoretical speculation, but in the past few months, the narrowing of the US trade deficit - and the boom in America 's export sector - have become observable facts. Since the summer of 2006, America 's deficit has shrunk by 1.5 per cent of GDP and the latest trade figures have shown US exports growing by 15 per cent in real terms, while imports grow by only 5 per cent. In the next two years, with the dollar now at record lows, this shift in the US trade pattern is likely to move even faster, adding 1.5 to 2 per cent to America 's growth.

The good news is that this export boost should be enough to offset the damage done by the housing slump to the American economy and its jobs market. The bad news is that the $400 billion worth of extra economic activity gained by US businesses and workers will be exactly matched by losses in Europe, Asia and the rest of the world. If this happens - and it is happening already - the biggest impact of the US housing slump may not be on America , but on its trading partners. And perhaps the most important questions about next year's economic outlook is which countries and regions will suffer most from the "improvement" in US trade. Most people's instinctive answer is that the countries most threatened by this reducing in the US deficit must be the ones that have the biggest surpluses against the US - China , Japan and the oil-producing countries.

If the US trade deficit shrinks by $200 billion or so in each of the next two years, simple arithmetic seems to suggest that the trade surpluses of other regions will have to fall by the same amount.

Because Japan , China and Opec are the only US trading partners with surpluses that big, it seems natural to assume that they will be the ones that suffer from the loss of US trade. However, this simple arithmetic is misleading: the US trade deficit could easily shrink by $200 billion or more, even if the Chinese and Japanese surpluses stayed as big as they are today or kept expanding. This could happen if Europe moved from its present position of rough trade balance, to an American-style deficit of several hundred billion dollars. In that case, Europe would prove more vulnerable than Japan , China or the Middle East to a US slowdown, just as it did in 2000-02 and in 1991-93.

How likely is this to happen in the next year or two? Most European policymakers and businessmen seem to think that it is impossible. Europe, they say, has never had huge American-style deficits in the past, so why should they suddenly emerge now? Sadly for European exporters, the answer is quite simple: currency movements !!!

Although today's media headlines and market chatter are dominated by stories about the "collapsing" of the dollar, the real currency story of the past few years has not been the devaluation of the dollar, but the revaluation of the euro and the pound. The fact is that the dollar has scarcely been devalued at all against the important Asian currencies - it is worth exactly the same against the yen as it was three years ago.

Meanwhile, the euro and the pound are now 20 per cent more expensive, not only against the dollar, but also against the yuan and the yen.

To make matters worse for European exporters, the character of America 's trade adjustment is now undergoing a change. Whereas last year's narrowing of the US trade deficit was caused mainly by a slowdown in US consumption, the global trading system is now moving into a phase in which the devaluation of the dollar becomes the main driving force. This is because a currency movement typically takes two years or more to affect exports, and so the full effects of the weak dollar on global trade patterns will only be felt in the two years ahead. As a result, the marginal producers of goods for the American market are much more likely to be European than Chinese, South Korean or Japanese. Moreover, the biggest trade effects of the dollar's decline against the euro are likely to be seen not in the American or European markets, but in third countries where European manufacturers compete against American, Japanese and other Asian rivals on roughly even terms.

These are the markets in which European exporters will be squeezed out most readily by price competition from their Asian and American rivals
.

In sum, it may seem natural to think of companies such as Toyota , Sony or Samsung as being most vulnerable to the present US mortgage crisis, but the real casualties of a US slowdown will probably be the likes of Volkswagen, Philips and Nokia.