Churchill Knight Blog

Inflation continues to worry, particularly in view of low growth rates. Some time ago the Institute of Directors’ Chief Economist, Graeme Leach, warned of the possibility of what he called “stickyflation” – rising prices against a backdrop of zero economic growth. The Consumer Prices Index has hit an annual rate of increase of 3.7% and the Retail Prices Index, which includes housing costs and therefore probably represents a more accurate picture of how families are affected, 5.3%. Six months ago, the CPI was rising at 1.5% and the RPI actually in negative territory.

While there is still some economic growth – especially if what the Bank of England says are temporary factors affecting inflation quickly pass out of the system – this might not be a problem. But the impact of quantitative easing is still such that there is more money in the economy than there should be and this can be inflationary.

According to the Bank of England’s own projections in its May Inflation Report, there is more than a 75% chance of overshooting the 2% CPI target during the second quarter and a 25% to 50% chance of overshooting the target in every quarter from now until the second quarter of 2013. This is actually worse than its forecasts in the February Report.

May was something of a rollercoaster for most markets, with the FTSE100 ending the month -6.57% down. In fact it is now just over 4% lower than at the start of the year, but still 17% up over12 months. The main cause for this – and the poor performance of other markets – has been concern over the Eurozone, thanks to the economic condition of Greece and some of the other southern European countries. In the case of the FTSE100, this has been exacerbated by some internal issues, such as the 14% loss in value suffered by BP during the month as a result of the ongoing Gulf of Mexico oil spillage and the 6.6% loss of value in Prudential’s shares, as it struggles to gain acceptance for its proposed purchase of AIA (AIG’s Asian business) for what is increasingly looking to be too high a price.

The mid-cap FTSE250 lost -7.03% of its value last month, but is still more than 3.5% higher than at the start of 2010. Meanwhile, on the other side of the “Pond”, the Dow Jones was down -7.92% and the Nasdaq100 -8.29%. Worst performer for the month was the Nikkei225, which lost a whopping -12.17% of its value during May.

Gold, which had peaked at more than US$1,240 per troy ounce during May, ended 3.48% higher at US$1,219.33, while oil, which peaked at about US$90 per barrel for Brent crude 1-month futures, ended the month -15.35% down at US$74.02.

Sterling fluctuated significantly against the euro during May, hitting a low of €1.14 before ending 2.91% higher at €1.184. Conversely, it lost some -4.9% of its value against the dollar (which is why fuel prices have not fallen as much as crude prices might suggest), ending at US$1.45.

The good news is that (as we predicted last month) growth for the first quarter of 2010 has been revised upwards to 0.3% from 0.2%. The fact that this is slower than the revised figure for the end of 2009 is, according to the Bank of England’s Inflation Report for May, probably due to temporary factors such as the weather. Business surveys point to a return to faster growth for the second quarter and few now predict that even the first tranche of spending cuts will push us into double-dip recession. The Bank of England’s projections for Gross Domestic Product growth are in the 2% – 3% a year range for the end of this year and beyond.

Unemployment rose slightly during the first quarter of 2010, just scraping above 2.5 million; which is good news for the economy generally, even if not for those directly affected. With the economy set to continue growing, we can be hopeful that the employment rate will soon bounce back to regain its 0.3% fall (to 72%) over the first quarter.

The first round of public spending cuts will only be the tip of the iceberg as we already know, and while we may not be in as deep trouble as Greece or Spain, we certainly must start living within our means. This is likely to involve unpleasant cuts in many aspects of public expenditure and, while steps must be taken to protect front-line services, it is interesting to note that according to the Sunday Times (16^th May) average regular pay in the public sector is almost £460 a week, while in the private sector is it only just over £420 a week. This gap of almost 10% is in addition to the fact that most public sector employees enjoy final salary pension schemes, while many of the rest of us do not.

This is by no means critical of public sector workers, simply a recognition that the cost of government is simply too high. Cuts need to be made but should, wherever possible, be sensitive to the needs of individuals. Better that they suffer a pay and recruitment freeze, than lose their jobs.

While a coalition may not have been the result that the main parties wanted, this appears to be the will of the electorate. Perhaps more importantly, it could enable the government to be more radical in its fight to put the economy back on a sound footing than might have been the case had the Conservatives won an overall majority.

It is not that they might have been any less committed to slashing state spending if standing alone but rather that, if the Governor of the Bank of England was correctly quoted as suggesting that whoever won the election would face a generation in opposition, then a problem shared is a problem halved. In other words, the Conservatives – clearly the senior partner in the coalition by right of seats and popular votes – can do what it really must, while sharing the “blame” with the Liberal Democrats.

This is not, however, a one-way street. In return for fulfilling the vital function of helping to take the flak, a party that has been in opposition since its last coalition participation during the Second World War (and even then, it had no places in the War Cabinet) will benefit from being able to gain experience in power and demonstrate what it can do.

Whether or not we like the idea of proportional representation and the prospect of semi-permanent coalition government, a broadening of the political spectrum now seems inevitable. What effect it will have on the long term economic future has yet to be determined.