22.01.2007 01:19
UK economy buoyant but financial crash looms if assets rise further - ITEM
LONDON (AFX) - The UK economy has entered the new year in rude health but could face a financial crash if asset valuations continue to rise at their current rate, a leading economic consultancy said today.
In its latest assessment of the economy, the Ernst&Young ITEM Club said buoyant monetary and credit conditions are working through the financial markets into household earnings and employment.
The ITEM Club, which uses the same economic model as the Treasury, is predicting growth in GDP of 2.9 pct in 2007 as the City of London continues to drive corporate activity. The forecast is based on an unchanged repo rate of 5.25 pct.
ITEM Club added that consumers will begin to feel the benefits as the demand for labour picks up and earnings improve over the next few months through lower utility bills and raw material costs.
That puts the ITEM Club in the middle of the 2.75-3.25 pct range forecast by Chancellor of the Exchequer Gordon Brown in last December's pre-budget report. Brown's forecast was seen as too optimistic by many observers.
Despite that positive growth profile, Peter Spencer, the ITEM Club's chief economic advisor, warned about
the 'worryingly high' growth of money and credit.
'This monetary expansion is
inflating asset prices and transactions and boosting both the activity and the profitability of financial services,' he said.
'If asset valuations continue to rise there will be a strong case for raising interest rates higher later in the year to bring the markets to heel and protect the economy from a financial crash,' he added.
In 2006, the FTSE 100 increased by 11 pct to a six-year high while the wider FTSE 250 index was up by 27 pct. Meanwhile, all measures of house prices continue to show that the market has largely brushed aside the August and November interest rate hikes from the BoE.
On monetary policy, Spencer said this month's interest rate hike to 5.25 pct was 'a warning shot' from the Bank of England to wage negotiators that the 2 pct inflation target is 'non-negotiable'.
'Settlements must be based on the target not the inflation headlines,' he said.
The rise in the CPI inflation rate to 3.0 pct in the year to December, its highest in 12 years, together with the increase in the RPI measure to a 16-year high of 4.4 pct, has sparked many headlines over the last few days.
If earnings don't rise too much, the ITEM Club reckons that the strong growth in the UK's labour supply from immigration and higher participation rates from those of pensionable age, coupled with the fall in world oil and commodity prices should be sufficient to bring CPI inflation back down to the 2 pct target by the end of the year without another rise in interest rates.
pan.pylas@thomson.com
---------------------------------------------
Mideast equity market crash portends global asset price shocks
by Dr Marc Faber
Wednesday, January 10 - 2007
'Excess Liquidity' has become a buzz word in the investment community and there is little doubt that excessive money supply and debt growth in the US which lead to a $800 billion US current account deficit is largely responsible for too much money chasing too few assets.
However, we should not overlook the possibility that excess liquidity can vanish rather rapidly. How so? In the case of the Middle Eastern oil producers liquidity began to shrink for three principal reasons.
When stock markets turned down in late 2005, marginal and highly leveraged investors had to sell equities in order to meet margin calls. This pushed prices lower and triggered further margin calls, which pushed prices even lower.
Then, the stock market boom was also accompanied by a huge real estate boom. Condos and houses were bought off plans and as construction progressed, the buyers had to meet the payments for their properties.
Mideast realty boom
This drained money from the financial market into the real economy and put additional pressure on equities, which were then liquidated to meet the installments for the purchased properties. At the same time, the OPEC countries went on a spending binge and imported an increasing quantity of goods and services.
Because after late 2005 oil prices and oil production no longer increased and OPEC revenues leveled off, a more than doubling of imports to an annual rate of close to $350 billion since 2004 meant that the OPEC governments' surpluses diminished rapidly and led to overall tighter liquidity in the system. I am mentioning the Middle Eastern experience for several reasons.
Rising asset markets always lead to increased liquidity because it allows the speculators to leverage up - that is as asset prices increase the loan value of these assets also increases, and additional loans can be obtained against the rising asset values.
Conversely when asset prices decline (and we had a taste of it in the April/May 2006 sell-off), leveraged positions are reduced, liquidity immediately shrinks, and volatility increases.
Tighter liquidity
Therefore, I believe that the pundits who are looking at signs from the real economy of money becoming tighter, which will in turn bring down asset markets, will be disappointed.
It is the asset markets, which when they begin to decline will provide the first sign of excess liquidity shrinking. In the US, we have the first symptom of liquidity getting tighter in the real estate market. The value of sub-prime loans has recently collapsed. A second symptom of tighter liquidity is evident from a slowdown in debt growth among US households.
By itself a slowdown in household borrowings does not imply a decline in asset markets because a lower rate of debt growth by households can be offset by higher corporate borrowings and higher leverage of the asset shufflers who believe that low volatility is here to stay.
However, it indicates an increasingly fragile financial house of cards, which is vulnerable to a shock from wherever it may come.