The rally has continued in the major markets. More money is getting through to share markets, as the quantitative easing policies of the UK and the US continue to feed dollars and pounds into the system. Investors are relaxing about the state of the banks, taking some heart from better profit figures from a couple of the US investment banks.
We remain concerned about the impact of ending quantitative easing, and the build up of such large US and UK government deficits. We regard this rally as a good opportunity to sell any remaining holdings of UK shares and bonds, as the adjustments that have to be made to the UK accounts will be large. The US position is a bit easier, as its banks are smaller in relation to GDP than the UK ones are in comparison to the host economy. The US also draws strength from issuing the world’s reserve currency. The US, however, has a large public deficit to tackle sometime, and US shares are no longer cheap on earnings multiple and dividend grounds.
We still prefer the Asian markets, which have risen more from the lows against the background of much better prospective growth rates than the West allied to less obvious problems in their banking systems.
The figures emerging in the UK show a big loss of revenue from property, income and sales taxes as the recession bites. They also show a rapid increase in unemployment, and therefore in the number of people on benefits. The government now accepts that spending will need to be constrained after the General Election, likely to be in May 2010, but is doing nothing to rein it in beforehand. The large issues of welfare reform, public sector pensions reform and the size of government remain largely untouched.
The apparent stability of the UK system rests upon the requirement on the banks to hold more short dated government paper, on the closure of pension funds who in turn are buying more gilts, and on the Bank of England’s large buying programme of government paper. The Bank may add another £25 billion to its purchases at a future Monetary Policy meeting, but we must be getting towards the end of their programme. The commercial banks will probably hit their targets for more liquidity required by the Regulator quite soon, leaving just the pension funds as the main natural buyer of government bonds. This could put more upward pressure on interest rates for government borrowing.
Meanwhile, the need for the banks to hold more government bonds reduces the amount they can afford to lend to the private sector. The measures needed to cut the deficit, coming on top of the rush of the private sector to cut its indebtedness, will mean a slower growth rate once the recession does lift. The excesses of the last decade will take time to work off, at a cost to the general economy.