Issue 76 | December 2009

Seasons Greetings
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A reminder that markets remain fragile

UK Equity Market: FT All-Share index: last 6 months

ASX--FTSE ALL-SHARE INDEX

Daily 6/3/09 – 11/30/09
Last Price 2659.76
High on 11/16/09 2756.46
Average 2468.20
Low on 07/10/08 2109.32

Source: Bloomberg
The UK market: a reminder that markets remain fragile
After starting November in highly volatile trading conditions, resulting in the FTSE100 index falling back to just above the 5000-
level, the US, UK and European stock markets then entered a period of strong upward momentum. The combination of central
banks confirming their committment to keeping interest rates low for an ‘extended period’ and the UK’s Monetary Policy
Committee’s move to extend its quantitative easing programme provided a broad lift to investor sentiment. A similar message
from the G20 meeting that the stimulus programme would remain in place until economic recovery was entrenched, provided
further impetus to equity markets. Positive wide ranging economic data from China, better than expected retail sales growth
in the US, and a return to GDP growth in the eurozone and the US all helped to drive the FTSE100 index higher towards the
5400-level (a thirteen month high) in the middle of the month. This strong rise in the index had been achieved on thin trading
volumes. However, having reached this level it seemed to bring back investor worries over the still uncertain outlook for global
economic growth and central bank policy (despite earlier firmly stated committments), and resulted in a sharp reversal in the
markets – again on low turnover – as risk aversion and a certain scepticism over the sustainability of the rally since last March
returned. Although stock markets then rallied again on broadly positive economic news. Towards the end of the month,
however, Dubai World, the Middle Eastern state’s flagship holding company, stunned creditors by announcing a restructuring
and asking for a debt standstill, sending the FTSE100 index sharply lower (minus 3.2% on the day) not helped by Wall Street’s
closure due to the Thanksgivings Day holiday. This event acted as a reminder of how fragile investor confidence remains
despite the general view that the Dubai problem would not derail the global economic recovery.

Sector Performance during November 2009

Top 5 % Bottom 5 %
Mining + 15.9 Construction & Materials - 4.2
Industrial Metals + 14.3 Electronic & Electrical Equipment - 4.0
Personal Goods + 9.1 Tobacco - 3.9
Gas Water & Multiutilities + 6.9 Aerospace & Defence - 2.9
General Retailers + 6.8 Support Services - 2.9
Source: FTSE International Limited

FTSE 100 Company results due in December

Company Date due Type of result
TUI Travel 1 December Final
Thomas Cook Group 2 December Final
Sage Group 2 December Final

Source: companies

Economic Indicators due in December

Announcement Date
ECB interest rates 3 December
UK interest rates 10 December
UK Consumer Price Index (inflation) 15 December
US interest rates (FOMC) 15 December
UK employment figures 16 December
Eurozone Consumer Price Index (inflation) 16 December
US CPI 16 December
UK retail sales 17 December
Monetary Policy Committee meeting notes 23 December
Lagging other leading economies
The UK’s preliminary gross domestic product (GDP) data, released by the Office of National Statistics (ONS) in late October,
revealed a contraction of 0.4% for the third quarter of 2009. This figure was greeted with disbelief by nearly all commentators
as recent surveys, and early official data, had pointed to a much more positive picture of economic activity in the UK. Most
particularly these had included the Markit/CIPS purchasing managers’ index, which economists, and the Bank of England,
regard as the most reliable of all private sector surveys. The consensus view, including that of the Bank, had been for weak,
but positive, growth of around 0.2%. Preliminary data is an attempt to provide an early snapshot of the economic performance,
and is often revised as it is based on limited hard data. However, the just recently announced first revision to the GDP figure
maintained the disappointment showing only a marginal improvement to a contraction of 0.3%, confirming the continuing
major difficulties facing the UK economy in extricating itself from recession. This was exemplified by the 0.8% decline in
industrial output, a fall of 0.1% in services and flat consumer spending figures over the quarter. Inventories also continued to
fall as companies have not yet commenced restocking, although when this does occur it will provide a one-off strong boost
to growth. By contrast the world economy continues to show signs of recovery, particularly in the emerging economies, but
also in nearly all the major industrialised countries, including the US where revised GDP growth in the third quarter was sharply
higher at around 0.7%, reflecting increased household spending, although much of the improvement to growth was due to
temporary measures. The eurozone has also just managed to escape from recession recording growth of 0.4% in the third
quarter (the second quarter recorded a 0.2% contraction), led by 0.7% growth in Germany (following 0.3% growth in the
second quarter) and France, although growth in the latter was weaker at 0.3% - the same level as that recorded in the second
quarter.

GDP projection based on market interest rate CPI inflation projection based on market interest
expectations and £200 billion asset purchases rate expectations and £200 billion asset purchases

Source : Bank of England

The contrast between the downbeat manner in which the governor (Mervyn King) of the Bank of England delivered the Bank’s
November Quarterly Inflation Report, and its significantly upwardly revised forecasts for GDP growth in 2010 and 2011, over
those set out in the previous Report, served only to confuse commentators further. The Bank’s August Inflation Report
forecasted GDP growth of 1.9% in 2010, this has now been upgraded to 2.2%, and growth of 3% for 2011 sharply raised to
4.1% in November’s Report. These forecast levels of growth are significantly above those of City economists (at 1.2% in 2010)
and those of the Treasury at 1% to 1.5% in 2010 and 3.25% to 3.75% in 2011. These are the strongest set of figures of any
forecast it has made since it was granted independence in 1997. Even when the figures are adjusted for downside risks, such
as the effects of a sharp fiscal tightening and continued dislocation in the credit markets, the Bank’s detailed November
forecast is for growth of 1.5% in 2010 and 3.1% in 2011 – both still at the top end of most existing forecasts.
The Bank of England’s new forecasts are based on a combination of positive factors including the record low levels of interest
rates, the fall in the value of Sterling (by around 25% on a trade weighted basis) supposedly aiding exporters, and the £200bn
being spent on quantitative easing, ie an unprecedented level of monetary relaxation. Added to these factors the global
economy is showing signs of recovery with the International Monetary Fund predicting growth of around 3% in 2010, although
it remains significantly below pre-crisis levels, and a significant part of that recovery can be attributed to temporary factors,
such as the various car scrappage schemes. Even so the recovery should support an improvement in the UK’s net trade
position, although the evidence sofar is that this has not occurred as imports continued to rise faster than exports – partly due
to a strong rise in imported cars reflecting demand for the car scrappage scheme. Negative influences, which will constrain
growth, include continuing tight credit conditions for businesses and households, tax increases (VAT will return to its old level
of 17.5% in the new year) and cuts to public spending. (The Bank’s forecasts were conditioned on the fiscal plans set out by
Labour in its last Budget, which implied a marked rise in public sector debt compared to GDP, with the stabilisation and
subsequent reduction in those levels requiring a combination of a reduction in public spending and a rise in taxation.) All these
factors will squeeze incomes and economic activity, as companies and households continue to look to improve their financial
position by a combination of reduced spending and higher savings.
The consumer prices index (CPI) of inflation rose sharply, as widely forecast, to 1.5% over the 12-month period to October,
up from its low point of 1.1% in September, marking the end of 12 months of decline from the recent high point of 5.2% in
September 2008. This rise was primarily due to a sharp fall in oil prices last year which were not matched in the current year.
Fuel prices dropped by 6.1% in October 2008 and by only 0.7% this year. Other contributing factors to the change were small,
with upward influences from food, air fares and computor games offset by downward pressure from banking services and
university fees. The more widely used retail prices index (RPI) rose from minus 1.4% in September to minus 0.8% in October,
due to similar factors as affected CPI but also a recovery in property prices. These figures remain substantially above the levels
recorded in the US (-0.2%) and the Eurozone (-0.1%).
Most commentators are forecasting further rises in inflation over the coming months as a combination of stable to rising fuel
prices compared to sharply falling oil prices a year ago, the end of the temporary cut in VAT in January 2010, and the
continuing effect of the fall in Sterling affecting import prices. All these factors point to CPI inflation rising to 2.7% in the first
quarter of 2010, and possibly 3% later in the year. The Bank in its Inflation Report comments that these rises should be
temporary and it expects the level of inflation to subside back to the government’s target level (2%) over the longer (two year)
term. The Bank has signalled that it will take a relaxed attitude towards a short-term sharp rise in inflation as it expects the
substantial spare capacity in the economy to restrict GDP growth, and wage freezes (or low growth) to curb future price rises.
Nevertheless, the extent to which CPI inflation will deviate from its target levels remains highly uncertain as it depends on a
number of factors such as the timing and strength of the economic recovery, the impact of the downturn on spare capacity
(labour not employed and capital not being put to productive use) on the economy, the extent to which companies adjust
prices due to higher import costs and whether there are further significant movements in energy and commodity prices. On
balance the Bank believes the risks of inflation being above or below target level two years from now are broadly balanced.
The prospects for a return to economic growth in the UK are gradually improving, although the recovery is likely to be slow
and unstable. The question remains, however, over whether the UK economy really can recover at the high rates now being
forecast by the Bank over the next two years. Although the UK economy would appear to have different factors adding to its
problems compared to previous recessions, most economists believe the similarities are greater, and thus the evidence from
previous recessions is relevant. These show that there is usually a sharp initial recovery in growth as the spare capacity in the
economy is rapidly closed. Nevertheless, the Bank’s forecasts would appear to require all the positive factors to stay in play
(monetary stimulus, low interest rates, a steady recovery in consumer spending etc.), while negatives (tight credit conditions,
tax increases, public spending cuts etc.) gradually fade away. The Bank strongly makes the point that small positive quarterly
movements in GDP will not alter the challenges facing the UK economy given the huge scale of the reduction in output
(approaching 6%) since the start of the recession some 18 months ago. In fact, even with growth at forecast levels, total output
will be well below levels that would have been achieved if the pre-recession trend had continued, infering that some of that
output may have been permanently lost. The UK has now got a reputation as a laggard (despite Gordon Brown’s ascertion)
compared to other major industrialised economies many of which have now emerged from recession. While there are valid
reasons, such as the UK’s greater dependence on financial services, the weakness of Sterling should by now have been a
significant help to growth in exports. This has not yet been the case. This leaves the economic outlook for the UK remaining
uncertain and highly challenging, and any recovery is likely to be weak and protracted.

First Equity Limited

Salisbury House, London Wall, London EC2M 5QQ
Tel: 020 7374 2212 Fax: 020 7374 2336
Website: www.firstequity.ltd.uk
Paul Henry
email: paul.henry@firstequity.ltd.uk

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