Smart Profits Issue #513
By Martin Denholm
Managing Editor For the first time in a year, I'll be heading back home to England next Sunday (assuming the planes are fit to fly, of course). And what a difference a year makes. Politically, the country is now "under new management." After 10 years in charge, Tony Blair finally handed the reins over to his #2, Gordon Brown. Brown is a smart fellow, who served as Britain's Chancellor (essentially the CFO) under Blair and did a good job keeping the economy robust. But he's the "anti-Blair" in terms of charisma. The dour Scot's demeanor matches the British weather perfectly: Grey and dreary. But there's one other big difference between then and now... Brown and his colleagues are currently in full defensive mode regarding the health of the UK economy. This wasn't the case one year ago. GDP growth was solid and headed higher... the Bank of England (BoE) was hiking interest rates (largely in order to combat rising inflation)... the pound was soaring against the U.S. dollar, making Britain an attractive investment destination... and despite some signs of weakness, the housing market was still pretty sturdy. But the goalposts have shifted now, forcing the Bank of England into its third interest rate cut since December on Thursday. Let's take a closer look... The US And UK: Partners In Monetary Policy "The chances that the UK economy will follow a similar path to that of the US now seem sufficiently high to warrant much more aggressive action from the Bank of England, akin to that taken by the Fed." So says Michael Hume, Lehman Brothers' chief European economist, quoted in the Daily Telegraph. Governor Mervyn King and the other eight members of the Bank of England's Monetary Policy Committee took another step in that direction on Thursday, slicing another 0.25% from the UK base interest rate and taking it down to 5%. Even in the face of rising inflation (largely due to surging oil prices) that, at 2.5%, is 0.5% higher than the government's 2% target rate, this signals that the BoE is comfortable with the outlook – and in fact expects it to decline later this year. Instead, it's placing more weight on the risks from falling GDP growth, the U.S.-born credit crisis, and the slumping real estate market. Passing The Buck To The Land Of The Buck Following his largely successful spell as Chancellor in Tony Blair's government, Gordon Brown is now the main man. Whether he relishes that brighter spotlight remains to be seen, but some have accused the Prime Minister of being stuck in Chancellor mode. When he was Chancellor, Brown was known for making rather bold GDP growth forecasts, then having to fight off the skeptics. It was a fight he often won, as his policies resulted in strong growth. But the times... they are a changin'. Today, Brown is fighting off claims that he's in denial about the state of the economy. For his part, Brown asserts that it's not just Britain facing trouble... it's the whole world, due to the "difficult situation arising from what's happened in America." He's probably right. But there's no doubt that having experienced a very similar housing bubble to America, the correction in the British housing market was inevitable, with or without external factors from the US. The latest numbers tell the story... Britain's Housing Market Is On A Shaky Foundation Talk about a shock. The Halifax released another dose of grim figures this week: - U.K. house prices dropped by 2.5% in March – the biggest monthly fall since September 1992.
- For the first-quarter, house prices declined by 1.1%, meaning the average cost of a home is now £191,556 ($377,396).
- With house prices now just 1.1% higher than this time last year, that represents the slowest annual growth rate since 1996 (I told you that times had changed!)
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So what does Brown say about this? Simply that the government is always "always vigilant." Hey, thanks! He also puts the fall in context, stating that after a 180% surge in house prices over the past decade and 18% over the past three years, a 2.5% drop is manageable. He also plans to hold a meeting next week with the Council of Mortgage Lenders (CML) to discuss the situation. But they've got some bad news for him, too – and this is where the credit crunch plays a big part... The CML added to the Halifax's gloomy report by stating that... - Just 49,000 mortgages were lent to homebuyers during February. That was 3.5% lower than January, 33% lower than February 2007, and the lowest monthly number since 1992.
- In the three months to February, mortgage lending to first-time buyers slumped to the lowest level since Q1 1975.
With the credit crisis having crushed the mortgage market and sharply reduced the number of mortgages on offer and banks' ability to lend to borrowers, these figures are perhaps not that surprising. And the International Monetary Fund (IMF) says it could lead to a £3,000 jump in annual mortgage bills. Overall, the large housing correction could shave 10% off UK home prices this year, according to the IMF, and with cheaper, fixed-rate mortgages set to expire for about 2.5 million homeowners over the next 18 months, the pain could get worse when coupled with rising consumer price inflation. Many are criticizing Brown and the government for allowing the bubble to expand and pop, rather than managing the situation better. From Brown To Darling... The Optimism Lives On At No. 11, But Nobody Is Buying It There must be something in the water at No. 11, Downing Street. With Brown having shuffled next door, Alistair Darling has taken his spot as Chancellor. And despite the problems facing the UK economy, he's keen to continue the streak of optimistic GDP growth forecasts. In his annual Budget last month, Darling pegged growth between 1.75% and 2.25% this year, rising to a range of 2.25% to 2.75% in 2009. By contrast, the IMF places the rate at just 1.6% both this year and next. Not only that, it says the UK housing market is still overvalued by 30% and the country is particularly at risk, because its financial sector makes up a large part of GDP growth. But Darling says the IMF downgraded the UK economy more than others and cites cause for optimism because the UK is well-placed to handle the shocks, thanks to its "extremely strong" and resilient economy, low unemployment, low government debt and low inflation. I know the government has a good track record of projecting GDP growth, but this is odd, since government borrowing is expected to surge to £45 billion this year and inflation is 0.5% higher than the target rate. Darling flew out to Washington on Thursday to attend the IMF's spring meeting with G7 nations, so it should make for interesting conversation! Still, he should be thankful he's not meeting with Michael Hume from Lehman Brothers (mentioned a moment ago). He claims that there is now a 35% chance of a "technical recession" (two straight quarters of negative growth) in Britain. The firm also projects an 8% drop in house prices by the end of 2009... has slashed its 2009 GDP growth forecast from 2% to 1.1%... and calls on the BoE to cut interest rates to 4%. Of course, some trends remain the same as my last trip to England... Dollar Still Getting A "Pounding" The dollar-pound exchange rate is still terrible for travelers on this side of the Atlantic. With one greenback currently buying a paltry 50 pence, I don't want to hear any more Treasury waffle about a "strong dollar policy" as I watch my dollars evaporate. You can play the long or short side of the pound easily through the CurrencyShares British Pound Trust (NYSE: FXB) – an ETF that tracks the currency's performance. Two More Brit Plays Not interested in currencies? One simple way to play the fortunes of the broader UK economy is through the iShares MSCI United Kingdom Index (NYSE: EWU). Investing in this 12-year old ETF would give you broad exposure to the price appreciation and yield performance of some of the biggest stocks on the London Stock Exchange. For example, it holds a 7% stake in energy giant BP, a 6.6% stake in communications firm Vodafone and a 6.25% stake in HSBC Bank. And despite the broader UK economic pressures, it's not all bad. You can always invest directly in the many solid British companies. I don't know if we're drowning our sorrows more because of the increased economic woes and consumer price pressures... but if there's one thing I do know about my fellow citizens, it's that we like a few bevvies. That's good news for London-based drinks producer Diageo (NYSE: DEO). I previously mentioned the company as a possible investment in my December 5, 2007 column when I talked about how the ethanol craze of last year led to a shortage of other crops. As this drove prices for corn, wheat, soybeans and barley higher, it subsequently triggered higher food and drink costs, too. Diageo is one of the world's oldest (founded in 1886) and largest drinks firms and is impressively diversified. The company owns major global beer brands like Guinness, Harp, Smithwick's and Red Stripe... Johnnie Walker, Bell's, and Bushmills whisky... Smirnoff vodka... Gordon's and Tanqueray gin... Captain Morgan rum, plus Baileys Irish Cream and Jose Cuervo. It has a presence in around 180 countries – so it's no wonder that it boasts a 20% profit margin and net income of $2.8 billion. Although the stock has shed a few bucks since December, it's still attractive precisely because of that diversification, bloated balance sheet and plenty of repeat business. The company also dishes out a generous $2.07 annual dividend per share (2.4% yield). And I'm sure I won't have too much trouble finding one of its products when I hit the homeland next week. Cheers, Martin Denholm Today's Smart Profits Notes: - Just as the Federal Reserve's interest rate cuts deflate the U.S. dollar, the Bank of England's cuts put a dent in the British pound. Although Thursday's was widely expected, it still didn't stop the pound from hitting a record low of 1.2457 against the euro, as the European Central Bank held its interest rates steady at 4% in the face of a 3.5% inflation rate. That's well above the bank's target rate of 2% and given that President Jean-Claude Trichet is on record as saying that fighting inflation is its main aim, many economists believe rates will remain unchanged for a while.
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