Survey of UK debt-inflation and interest rates - where next for the markets?-and a brief update on the funds.

Debt

How old is the credit crunch? Nearly three years, we’d say. It began in July 2007 with the bankruptcy of Northern Rock, though you could say it started in June the year before when the US housing market peaked. Three years on, people are saying ‘the debt problems haven’t gone away, and if anything it’s getting worse’. We decided to have a look at the borrowing figures for the three sectors of the UK economy, individuals, business and government, and see if we could draw our own conclusions.

Big numbers

Discussion of debt at the national level inevitably involves talking about large numbers. A billion is a thousand million. There are around sixty million people in the UK, and £1 bn is around £16 for each UK citizen. A trillion is a thousand billion, or a million million, so in terms of the UK population, £1 trn is around £16,000 each. For you and me, £1m is a large amount of money. For our government, £1bn is a relatively small amount of money, but £1trn is a huge amount of money. Our government debt is approaching £1trn, but hasn’t quite got there yet.

Personal debt

You may remember how, a few years ago, private sector debt became a hot news item, as it approached and then passed £1 trillion. You may also remember getting almost daily letters from companies offering to lend you money, or help you restructure your existing loans, and it’s a sign of the times that these letters have stopped coming. At the moment, personal debt is slightly below £1.5 trn. It continued growing until last November, but has been steady for the last seven months. Of this total, roughly £1.25 trn, or five-sixths of it, is mortgages on houses, and the rest is unsecured debt.

Currently, the entire housing stock of the UK is valued at around £4 trn, so the debt secured against it is a little over 30% of the total value.

In order to get a full picture, it also makes sense to look at other assets. The International Monetary Fund (I.M.F.) provides a figure of £2.5trn for total private deposit accounts in the UK.  So, interestingly, in debt-ridden U.K., the average individual has around £5 on deposit for every £3 that he or she has borrowed. The amount of money deposited has remained steady since the end of 2008 - since the time when it stopped being worth putting money on deposit. Finally, we looked at the figures for unit trusts. Three years ago, the total was £473 bn. Today, it’s £511bn, despite the market being around 20% lower than it was then, so people are continuing to invest.

In summary, the personal sector has borrowings of around £1.5trn against assets of around £7.0trn.

The savings ratio is the percentage of household income that gets saved rather than spent. In the mid-1990s, the savings rate was around 10%, and then declined steadily until it briefly turned negative in early 2008. The savings rate then kicked up sharply, peaked at around 8.5% in late 2009, and fell back to 7% by the end of the year. We don’t have any figures for 2010 so far, but the trend is clear. The savings ratio is now a lot higher than it was at the start of the credit crunch - habits have started to change.

Business

For some reason, figures on company borrowing in the aggregate are harder to get hold of than for the other two sectors. However, the figure we found for total company indebtedness is around £2.1trn, in other words, company borrowings come to half as much again as personal debt. The figure for net borrowings, the amount of borrowings less the amount of cash held on deposit, is £1.2trn, which is still a very large amount, but it means that companies in the aggregate are holding £900 bn in cash, a larger amount than the entire national debt. When you come to think of it, with interest rates low, it makes more sense to let cash pile up than to repay debt. Banks are in no mood to lend, so once you’ve repaid a bank loan you may not be able to re-borrow the money, or not on nearly such good terms.

Better to have a war chest to pay bank interest and other commitments, should times get hard again.

Government

There’s no getting away from it - the size of the UK government’s debt, and the rate at which it is growing, are scary. Total government borrowing is around £850bn. Last year’s deficit was revised down to ‘just’ £155bn, which is to say that in 2009-10, the government spent £155bn more than it received in taxes. Put differently, the government spent £4 for every £3 it received. There has been a national debt since the eighteenth century, but the size of the current problem is highlighted by the fact that almost one-fifth of the UK’s entire national debt was borrowed in 2009-10. The government is borrowing a new £17.5 million every hour, day and night, seven days a week, or roughly £300,000 a minute. And, as a result of last year’s deficit, our government will have to raise another £6bn this year, just to pay the interest on the money it borrowed last year. Unlike the personal and business sectors, government has no savings to offset against its debt.

Summary

The personal and business sectors present a mixed picture. There is a lot of debt, and there is also a lot of cash and other assets, but the debt and the cash tend to be in different hands. You hear more about the debt than the cash, because high levels of debt mean trouble, and trouble makes news. And we are, after all, in a credit crunch, not a cash crunch. As investors, we continue to look for companies that aren’t in trouble, and we continue to find plenty of them. The fact that many other investors are too scared or preoccupied just now to invest in those areas, has ceased to bother us unduly.

The government, however, is a different matter. In our view, the economy is like a hot air balloon. The private sector is the balloon, and the government is the basket. Over the last decade, the basket has grown steadily heavier, and as a result the balloon doesn’t fly too well just now. The new coalition government understands this clearly, and the emphasis of the budget next week will be on cutting public expenditure, rather than on raising taxes.

The alternative is a deficit which could spin out of control. The rate at which the UK government borrows is set by the institutions who lend it money. If these lenders lose confidence, they will demand an ever higher rate of interest, which would mean ever more of the national output being used to service existing debt, rather than being put productively into schools, hospitals and roads.

Inflation and interest rates

Our research indicates that overall, there is around £4.5trn of outstanding debt in the UK. The economy has started to recover feebly, but the recovery is fragile, and many expect a double-dip recession. Every 1.0% rise in interest rates would cost borrowers another £45bn a year in interest payments, which could cause a wave of bankruptcies and repossessions, and a sharp fall in house prices. So, surely, interest rates need to stay low? Yes, but there are looming inflation pressures. Let’s look at just two. One reason why inflation has been low in the West for the last two decades is because we have become used to buying ever more products from China at ultra-low prices. But today, price and wage inflation in China are well over 10%, and China’s currency is almost certain to rise against Western currencies over the next few years. Result - Chinese products are rising in price and they will exporting inflation rather than deflation over the next couple of years. Then there’s the price of oil. The risks of deep-sea drilling have become only too clear over the last couple of months, and the inevitable result is much tighter regulation, which must mean higher oil prices two or three years hence, if not sooner.

How can you have higher inflation with very low interest rates? At the moment, inflation is 3.4% and the Bank of England Base Rate is 0.5%. This rate is justified because inflation is expected to fall. If it doesn’t, then either interest rates must rise or the inflation target would have to be changed, or abolished.

The credit crunch happened because too many people borrowed too much money, and not enough people saved. However, rather than pursuing policies which would encourage saving and discourage borrowing, governments and central banks have done the opposite - in order to avert catastrophe they have pursued policies which help borrowers and penalise savers.

These have continued up till now. I once walked through a forest in California where there had been a fire a couple of years earlier. You could see that some trees, though fire-damaged, were going to survive, and were putting out green shoots. Others had died or were beyond saving. You might have thought that by this stage of the crisis, it would be equally clear who the survivors were in the financial forest, and which of the trees were doomed, but policy has been able to cure some of the problems and conceal others. Prudence has not been rewarded yet, but it will be in the end, we think.

MARKETS

Earlier this year, I predicted that the FTSE-100 would exceed 6000 on the rally, and as several alert readers have pointed out, it fell short by around 150 points, and as I write is just over 10% below its highest level (5833). However, the last couple of months haven’t been too bad for Wise Investment funds, which have comfortably beaten the market. We continue to feel uncertain about the short-term sustainability of Chinese economic growth, which is increasingly underpinned by dubious infrastructure projects undertaken by private sector companies set up by local government officials with borrowed money. These projects underpin the prices of many industrial commodities. It had been costly for us to avoid these areas, but since the market turned, the areas we invest in, which you could roughly define as ‘anything which can survive and prosper without significant borrowing’ have started to do much better.

The market downtrend that began in April isn’t over yet. We haven’t seen the pattern of steadily rising highs and lows that would confirm that the uptrend has resumed. On the other hand, there is a firmer tone now, especially in the areas of the market  we’re interested in, which is notable against a background of relentlessly bad news. It’s also worth remembering that 200 points of the market’s fall since April 20^th are down to one share – BP.

BP

Before the disaster began, BP was the UK’s most valuable company, worth a little over £120bn. Today, it is worth around £64bn - an astonishing £56bn loss, equivalent to nearly £1,000 for every UK citizen. For every £100 of dividend income paid by UK companies, BP pays £12.

We don’t know what BP will do about its dividend, but it may be suspended for a while, which would hit many income-paying funds (nearly half of the 88 funds in the UK Equity Income sector have BP as their largest holding). If BP cut its dividend, the total yield of the market would drop, and at a stroke the stock market would become less attractive relative to government stock on yield grounds.

TB WISE INCOME

Recent performance has been quite pleasing. From April 6^th, Wise Income has lost 2.6%, compared to a loss of 8.8% for the FTSE-100 index, and has performed with much lower volatility than the market. Over this period, Wise Income is 10^th in the Active Managed sector out of 136 funds. The fund has stayed more or less fully invested throughout this period, but we have used the bad days to top up holdings, particularly in higher yielders. TB Wise Income’s current yield ( ‘A’ Income shares) is 6.13% p.a., net of basic rate tax. This means that if we keep everything we own for the next year, and the income paid by all our holdings doesn’t change, the total income produced in the year will be 6.13% of today’s price.

How does BP affect our yield? Wise Income holds BP only indirectly, through unit trusts and investment trusts, and our best estimate is that around 1.5% of the fund is in BP. Assuming that a full year’s dividend is lost, the effect would be to reduce Wise Income’s yield from 6.13% to 6.0%. This is the ‘worst-case scenario’ assuming no income at all from BP.

TB WISE INVESTMENT

TB Wise Investment has had a good couple of months’ relative performance. Since April 6^th, when the markets turned down, the FTSE-100 is down 8.8%, and the fund is down just 3.1%, placing it 26^th out of 136 funds in the Active Managed sector. Volatility has continued to be far lower than that of the market.

Towards the end of April, cash in TB Wise was raised to around 18%, and we have recently begun to put the cash back into the market, reducing cash levels to around 10%, rebuilding holdings in Japan,  UK property and smaller companies, and establishing small new holdings in the healthcare, technology and energy sectors, all of which seem fairly recession-proof.

The private equity fund HG Capital, at 7.6%, is still TB Wise Investment’s largest holding. HG has been ‘boringly’ sitting on a pile of cash for the last couple of years, but has made five major purchases in the last few months, including an Austrian high-tech lock manufacturer, the largest provider of care for the disabled in Sweden, and the Isle of Man telephone company, in addition to making a further commitment to its alternative energy fund. Other private equity fund managers believe that the time to make investments has come, as good companies need rescuing in one way or another, and prices are more reasonable now. HG’s share price missed last year’s rally almost entirely, but there is a chance that the shares may be re-rated as the company moves closer to being fully invested.

As always, I’d be very happy to hear your views and comments.

With best wishes,

 

Tony

 

THIS BLOG CONTAINS THE PERSONAL VIEWS OF TONY YARROW AS AT JUNE15^th 2010, AND DOES NOT CONSTITUTE FINANCIAL ADVICE