Pre Pre-Budget Report

This year’s Pre-Budget Report on 5th December will be an uncomfortable experience for Gordon Brown. Having been proved right on the economy last year, this time he will have to admit he has got it hopelessly wrong.

Thankfully for him, two factors will save him from having to pay for his over-optimism, at least for now. First, the recent modest improvement in the monthly public finances figures will allow him to claim that, despite the downturn in the economy, public borrowing has come in broadly as he had expected. And second, previous changes to the estimated timing of the economic cycle, and other minor adjustments, have given him extra elbow room with respect to his own fiscal rules. As such, expect the PBR to contain little in the way of major policy measures.

But even Mr Brown cannot put off the inevitable for ever. Though the fiscal rules may be technically secure, the big picture is still one of a significant deterioration in the public finances over the last five years. Accordingly, taxes will probably have to rise by some £10bn per annum, though this might be delayed until the economy shows some recovery.

And who will be paying these higher taxes?

Speculation that taxes will need to rise in the UK has largely assumed that households will bear the brunt of any increases. And yet the recent weakness of household spending and the contrasting strength of company profits might suggest that the corporate sector is better positioned to withstand higher taxes. There is an obvious political motive for the Chancellor to aim his fire at companies too – unlike households, they do not vote!

But there is no free lunch for Mr Brown in raising corporate taxes. Any improvement in the outlook for household spending would be offset by the adverse impact on company prospects. Profits, investment and employment could all be hit, with the latter feeding back into household spending. Bottom line: Wherever tax increases fall, the key point for the economy is that fiscal policy is most unlikely to be as supportive as it has been over the last five or six years. That, in turn, points to a likely combination of relatively weak activity and loose monetary policy over the next few years.

Gas price surge won’t stop UK interest rates falling

Just as worries over the inflationary impact of higher oil prices had started to fade, the cold weather has sparked a sharp rise in wholesale gas prices. This will have implications for companies’ costs and profits, and impact on consumer price inflation. Wholesale gas prices have risen by some 125% over the last month to 102 pence per therm. Were this level to be sustained and reflected in retail prices, it could point to a rise in the annual inflation rate of the gas component of the CPI from October’s 17% to 65%. Given gas’ weight of 12 out of 1000 in the CPI, this could add 0.6 percentage points (pp) to the annual rate of CPI inflation.

But that is not the end of the story as gas is the primary input used in the electricity generation process. The rise in gas prices has also driven wholesale electricity prices up by 70% to £73 per Mwh. Taken together, then, the rises in wholesale gas and electricity prices seen so far could conceivably add a whopping 0.9 pp to CPI inflation. Indeed, the total impact on inflation could be even higher if there are additional indirect effects via the general upward pressure on companies’ costs.

That is the case for the Bears. Thankfully, however, there are several reasons why the actual impact is likely to be rather smaller than this:

• First, a number of domestic energy suppliers only recently announced large hikes in their gas and electricity prices. This could mean that they are able to absorb at least part of the latest rises in wholesale prices within their margins.

• Second, some domestic energy suppliers, such as Powergen and Npower, are now offering services allowing customers to freeze their energy bills until 2007 or 2010.

• And third, retailers do not respond to every short-term fluctuation in wholesale prices. If wholesale gas prices were to quickly drop back, as industry speculation has suggested is possible, than retail prices may see little impact.

Overall, Capital Economics estimate that gas price inflation could add an extra 0.2% or so to total CPI inflation. These effects should be offset by falls in other components like petrol and core prices, but they will nonetheless prevent CPI inflation from falling back as quickly as it would otherwise have done. What’s more, the effect could obviously be bigger if the gas price increases are sustained. Bottom line: With higher utility prices likely to continue to depress activity and the MPC focusing on the two-year inflation outlook, do not expect the surge in gas prices to prevent interest rates from falling early next year and beyond. A rate cut in February to be followed by further reductions over the spring and summer, could bring rates down to just 3.5%.

Global Equities: From Headwinds To Tailwinds

Global equities should continue to benefit from the recent decline in energy prices, bond yields and Fed interest rate expectations.

Global equities have rallied about 5% since early November, reaching a new cyclical high. The gains have been fueled by reversals in several key equity market drivers. Lower oil prices have boosted global growth prospects and helped temper headline inflation concerns. The latter, in turn, has enabled bond yields to drift lower, thereby bolstering stocks. Meanwhile, the latest FOMC Minutes indicated that a shift in rhetoric is likely in the December policy statement, suggesting the end of the tightening cycle is drawing nearer. Stocks may face a period of earnings disappointments in due course, but the uptrend should persist in the near run.

ECB Rate Hikes: More rebalancing than “normalization”

ECB interest rate hikes will not follow the experience of the persistent Fed’s “normalization” process that began in June 2004. ECB President Trichet made it clear last week that this Thursday’s almost certain rate increase is not the beginning of a prolonged series of U.S.-style hikes. Euro area money markets agree with Trichet. Expected ECB hikes are similar to the moderate increases expected of the Fed over the next 6 and 12 months. In contrast, 6- and 12- month expectations of U.S. rate hikes blew out to 120 and 200 basis points, respectively, in mid-2004 when “normalisation” was at an early stage. Bottom line: The 50 bps of hikes expected over the next six months will be more a rebalancing of monetary conditions to offset euro weakness than a tightening.

And finally……….

After numerous rounds of: "We don't even know if Osama is still alive", Osama himself decided to send George Bush a letter in his own handwriting to let him know he was still in the game.

Bush opened the letter and it appeared to contain a coded message:

370HSSV-0773H

Bush was baffled, so he e-mailed it to Condi Rice.

Condi and her aides had no clue either, so they sent it to the FBI.

No one could solve it there so it went to the CIA, then to NASA.

With no clue as to its meaning, they eventually went to the very top and asked Britain's MI-6 for
help.

MI-6 cabled the White House:

"Tell the President he's holding the message upside down."

Prometheus from sources: ADM, Barclays Capital, Cazenove, Charles Stanley, HSBC, ING, SocGen, UBS.