Pre-Budget Report 2005

Bloodied, but unbowed

Gordon Brown swapped his annual Santa Claus act for something closer to Robin Hood, taking from the rich oil companies to give to poorer families and pensioners. Sooner or later, however, he will have to play King John and raise taxes to put the public finances back on track.

Not surprisingly, Mr Brown blamed this year’s economic slowdown on things beyond his control, such as the high oil price and weakness of overseas economies. But this jars with the MPC’s assessment that household spending has been weighed down by a rising tax-take and other domestic factors.

Inevitably, he predicted that the economy would recover next year and beyond. As a result, while annual borrowing will now be £5bn higher in 2007-08, it will return to its previous expected path later in the forecast period. This keeps the Chancellor’s fiscal rules safely intact.

But Mr Brown’s scenario remains firmly at the optimistic end of the spectrum. His prediction of a strong pick-up in the economy next year and beyond relies on the fact that the recent downturn has been cyclical - the weakness of productivity suggests that longer-lasting forces may be at work. Meanwhile, he continues to rely on a sharp rise in the ratio of tax receipts to GDP. Were it not for the various adjustments already made, the Chancellor would be on course to break his own Golden Rule comprehensively. But whether or not the Rule is broken, the big picture remains one of a very dramatic deterioration in the state of the public finances over recent years. Even his own optimistic forecasts see public borrowing of some £26bn in 2008-09, providing little scope for the economy to continue to disappoint.

Accordingly policy action, probably in the form of tax increases, will eventually be required to get government borrowing back down to acceptable levels. The fact that the economic cycle is now not expected to end until 2009 means that Mr Brown can avoid raising taxes while the economy remains so weak, but he cannot put off the inevitable forever. Bottom line: Tax hikes or no tax hikes the key point for the economy is that fiscal policy will be much less supportive over the next few years than it has been over the last few and that, in turn, points to a combination of relatively sluggish economic activity and loose monetary conditions.

OIL SECTOR – The Chancellor announced changes to UK North Sea tax rules in his report: 1) raising supplementary tax from 10% to 20% - effectively taking the marginal rate of UK North Sea tax from 40% to 50%, 2) extending incentives for exploration, especially on difficult, high risk projects, 3) enhancing incentives for biofuels and carbon capture projects.  This is roughly what was expected and should be no surprise to the market.  The implications for individual companies are as follows:

• BP - with <5% of production located in UK North Sea, reduces core NAV from 768p to 760p, a reduction of just over 1%. Changes will have little material impact on tax rate and EPS forecasts.

• BG - with c.20% of core NAV located in North Sea, change reduces core NAV of 440p to 429p, a reduction of c.2.5%. Stock may also suffer a higher rate of tax and average tax rate may rise from 40% to just over 45%.  If that is so, there may be reductions in forecasts - 06-07 EPS from 39.1p & 41.3p to c.35.6p & 37.5p, a reduction in both years of c.10%.

• Royal Dutch Shell - with <10% of value in North Sea, reduces core NAV from 2450p to 2400p, reduction of c.2%.  Again, we doubt changes will have material impact on tax rate or EPS forecasts.

REITs - The introduction of legislation for REITs was pretty much as expected with the framework agreement having been in place and batted back and forth between the Treasury and HM Revenue and Customs for some months. There are some positives and some negatives and market probably hoped for bit more, so having had a strong run over the past month (+7.6% absolute) the sector might give up some of its recent gains but overall we do not see any major sell off whilst there remains the prospect of a REIT being introduced next year. Bottom line: Will devil be in the detail?

Europe: How Much More ECB Tightening Ahead?

The Purchasing Managers Index (PMI) for services points to only moderate ECB policy tightening ahead. It  confirms the view that the euro area is currently in a “sweet spot” of moderate, but improving growth with little sign of rising inflation. The business activity index increased for the third consecutive month in November, indicating that the service sector will continue to expand at a gradual pace in the months ahead. The employment measure heralds gains in job creation and the price measures suggest that pressure on profit margins is abating. On the other hand, the indexes at the national level point out that domestic demand is still sluggish. Bottom line: Growth is likely to remain tame and an aggressive policy tightening will not be needed.

Japan: The Weak Yen Is Helping Japanese Stocks

Japanese stocks are getting substantial support from a weak yen. They have been among the world’s best performers since late-April, gaining roughly 40%. The advance has been aided by a substantial decline in the yen versus the U.S. dollar, which is boosting the profitability of major exporters in the automotive and electronics industries in particular. The weakness in the yen in recent months is especially noteworthy because the currency typically rises during economic and equity market upswings. The weak yen, in turn, largely reflects Japan’s ultra-low interest rates, which will persist through the first-half of 2006 at least. Bottom line: the combination of super-easy monetary policy and a cheap yen are bullish for Japanese stocks.

This encouraging scenario is supported by the relative health of Japanese companies as they continue to pare debt and boost profitability. Third-quarter financial statements highlight the increasingly robust health of the Japanese corporate sector. Operating profit margins remain at three-decade highs, and are especially elevated among the largest companies. The surge in profit margins has been driven by tight cost controls, with personnel expenses and investment outlays increasing much more slowly than during past cyclical economic recoveries. Fat profits have enabled companies to cut debt by nearly 20% in the past decade and reduce gearing relative to sales to a post-bubble low. While the rebound in corporate health is impressive, Japanese companies still offer substantial operating leverage to an end to deflation and ongoing economic recovery. Bottom line: Improving corporate finances should help underpin further equity market gains.

Technically speaking…..

The FTSE-100 closed last week with a gain of 4.3 points and although the rise was modest it means that the index’s winning run has been maintained, with the number of consecutive ‘up weeks’ now standing at six (the record for the year is still eight weeks in a row). That’s looks like a sure sign of a market that’s in rude health, even if the gains of the last month amount to just 100 points. One curious feature of this latest run is that it has not led to an overbought situation on the momentum oscillators - the 14-week RSI, for example, last peaked in August, and the MACD formed its last major top at the end of September (which coincides with the previous peak on the weekly chart). This probably means one of two things - either the index is running out of steam and this rally hasn’t got much further to go, or it’s a rally that has a certain ‘slow-burn’ quality and it’s only just getting going. One clue might lie in the monthly chart, which continues to look very promising - most oscillators are still trending higher and are showing few major signs of divergence, indicating that the rally which began more than two and a half years ago still has further to go. For now it seems best to follow that particular lead, although the fact that there are mixed signals on the index means that some caution should be exercised.

52-week high - 5531.7

52=week low - 4688.4

And finally………..something for the office Christmas party!

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