The UK’s budget deficit is a very deep hole indeed and it is going to take a very determined politician a long, long time to get the UK back to a balanced budget.  The borrowing requirement for 2009/10 is around £175 bln and next year (2010/11) it is forecast to be roughly the same at £180 bln. 

Take a quick look at the following HMRC table which shows all the money raised in taxes, etc. by the UK government in recent years.  In the best year ever (2007/8) a total of £451 bln was raised.  The recession has taken its toll and total revenues in 2009/10 are forecast to be £397 bln.

The most recent figures published by the Office for National Statistics show UK government current expenditure was £564 bln in 2008/9.

The difference between what the government spends and what it raises in taxes is just enormous.  And the difference is not simply the money spent on bailing out the UK banking system because these statistics exclude the money spent on financial sector interventions (deemed to be temporary spending).

Lets assume that the economy recovers and in a few years’ time HMRC tax revenues bounce back to their all-time high of £451 bln.  Also assume that all those people who lost their jobs in the recession find employment again and therefore subtract the £32 bln rise in social security benefits & tax credits since 2004/5 (i.e. well before the recession started) from the £564 bln the government spent in 2008/9.  This is how the deficit is halved by doing nothing except praying for a full economic recovery.  However it still leaves the UK with a structural budget deficit in the region of £80 bln.

This is not meant to be a political blog but sometimes politics impacts upon the economy and the markets.  This structural budget deficit of £80 bln is what needs to be tackled by the next government which is elected in May 2010.  Sadly no mainstream political party seems to be brave enough to spell out the size of the hole the UK is now in for fear that the electorate will be too afraid to elect them.  Whilst carrying on as before will appeal to the electorate because they think that way they will not get hurt, it is really not an option.

A future government will have to go further than the pay freeze for the highest paid public sector employees which Gordon Brown announced this week. However a problem with imposing public sector pay cuts is that for every pound the government cuts pay, it loses up to 40 pence in income tax revenue and the economy also suffers because the other 60 pence is not spent on goods & services anymore (with knock-on reductions in VAT collections, etc.).

The UK’s structural budget deficit is not entirely due to Gordon Brown’s tax & spend policies, but had he saved a bit when the going was good (instead of “investing in public services”) then we wouldn’t be in quite such a horrible mess today. 

However this £80 bln hole is what the 2010 election debate should be about - pace Bill Clinton, ”It’s the budget deficit, stupid”.

The first hint of higher interest rates in the States arrived after this week’s FOMC meeting.  Thomas Hoenig (President of the Kansas City Fed) emerged as the first interest rate hawk on the FOMC and voted against an unchanged monetary policy.  Hoenig “believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the Fed funds rate for an extended period was no longer warranted”.  In plain English Hoenig wants the Fed to signal to the markets that it is going to begin hiking interest rates at some stage in the not too distant future.

At the moment Hoenig is the only dissenter on the FOMC.  It will pay to keep a close eye on whether his view gathers support at future FOMC meetings.

The market’s reaction thus far to Wednesday’s announcement has been most evident in the US Dollar.  Its rally, which began after the 4 Dec 2009 Employment Report, has continued and the Dollar Index (DX) has now broken above its 200-dma.  The 50- and 200-week moving averages are the next resistance levels to be surmounted and they lie just above the current 79.59 level of the DX.  Hoenig hankering after US rate hikes will only serve to help the Dollar to extend its recent rally.  Commodities (as measured by the CRB index) have reacted badly, the US stockmarkets have remained under pressure (but they started falling two weeks ago) but the all-important US Treasury bond market has traded sideways despite Hoenig hinting at higher rates sooner rather than later.

However it is difficult to believe that the Fed is going to implement the first rate hike until the US economic recovery has gained significant traction which results in a very visible fall in the unemployment rate from its current 10%.  There is so much spare capacity in the States that the Fed can afford to let growth continue to build momentum without worrying about higher inflation resulting anytime soon.  Any premature rate hikes would be a serious policy error which would impact the economy & stockmarkets severely.

A more likely explanation for Hoenig’s action in voting against the others is that it allows the Fed to test the market’s reaction to a proposed change in the current policy stance of “low rates for yonks”.  If markets react badly over the next few weeks (particularly if the US bond market tanks) then we can expect all the other FOMC members to very publicly bang the drum that interest rates are not going up anytime soon.  The FOMC knows full well that it will eventually have to tell the markets that rates are not going to stay at “exceptionally low levels for an extended period” and this is a low risk way for it to prepare the markets for an eventual change in monetary policy.

I still think that the first US rate rise is out of view and over the horizon (and more likely to take place in 2011 than 2010) but will be paying close attention to future FOMC statements for clues as to when policy is likely to change.

Given that low Base rates are here to stay for a long while yet, which assets will benefit most from the BoE’s low-rates-for-yonks policy (which is primarily directed at halting the recession and, as a consequence of growth, reducing unemployment)?

Normally government bonds sell-off (higher yields) when the market sniffs an economic recovery but with so much spare capacity in the economy to be worked through, Base rates will remain low until a recovery is well under way and unemployment has turned decisively lower.  In this environment short-dated government bonds should continue to do well, especially for those within 5 years of maturity.  Longer-dated yields may well go higher (especially once the BoE finishes spending its QE money) with the result that we may see a very steep yield curve sustained for quite some time.

Credit spreads on corporate bonds should carry on tightening, although there will come a limit when the absolute level of the coupon offered scares investors – lending money to a BBB-rated corporate at, say, 3% for 5 years will surely make investors think twice.  The margins currently enjoyed by banks will also serve to stop credit spreads from tightening too far as banks enjoy better protection on their loans (so logically the credit spread on corporate bonds ought to be greater than banks’ lending margins).  A steep yield curve also benefits banks greatly too.

Commodities follow a price path all of their own as they offer no yield, so they offer little attraction to income-seeking investors.

Which brings us to equities. Yields in excess of government bonds coupled with low Base rates until a recovery appears mean that equities could quite easily become over-valued against the current backdrop of macro policy.  Companies with big pension schemes may not join the party as the combination of tightening corporate credit spreads and bond yields being held down by QE buying will result in lower AA-bond yields (which are used as the discount rate with which pension scheme liabilities are calculated).  This will temporarily result in bigger pension scheme deficits which the market may well take fright at (again) for those companies affected (the usual suspects are British Airways, British Telecom, etc.), but the effect will subside once the BoE stops propping up the gilts market and long-dated gilts sell off (higher yields).

Once the supply of fresh equity from companies raising money to pay down debt and get their balance sheets into better shape has largely abated, the coast will be clear to bid up the price of equities.  Any type of a recovery (slow & protracted would be ideal) will result in companies growing their top-line sales revenues, whilst all the cost-cutting implemented since the credit crunch hit in summer 2007 means that lots of that top-line growth will translate into higher profits.  And high unemployment rates also mean that workers won’t be getting much of this profit growth.

The obvious risk to this all-out bullish view is that the economy double-dips badly and the hoped-for GDP growth never materialises.  Until that prospect (which looks very unlikely at the moment) seems much likelier to happen, it will not pay to be bearish on equities.  The Bank of England is too worried about spare capacity bearing down hard on inflation to care much, for the time being, about an asset bubble developing in equities.

So has the economic recovery arrived or will the economy slip back into recession?

For many, this is the key question du jour and the answer will determine whether the recent stock market rally will prove to be just a bear market rally or the start of the next bull market.  Bull markets climb a wall of worry and amongst those currently worrying will be the camp who believe ”this cannot be a new bull market because the rally didn’t start from a single-digit p/e valuation level”.

By definition an economic recovery has to start with an initial single quarter of positive GDP growth (France & Germany reported positive GDP in Q2 and it is likely that the US & UK will report positive GDP in Q3).  Whether what follows are many more quarters of positive GDP growth nobody can know for sure at this stage.  This is why stockmarkets rally ahead of the first positive quarter as they are always trying to discount the future.  If this proves just to be a short-term bounce in GDP (driven by low inventories & pent-up demand) and the economy slips back into recession next year then stockmarkets will go back down again.  Whether they plumb the depths seen in the post-Lehman panic is most unlikely.  We have seen a V-shaped bottom in the markets since Lehman went bankrupt last September and these are most often associated with forced selling (c.f. March 2003 when the insurers were dumping equities).  Once all the forced selling is completed there are no sellers left and markets bounce back up again.  The stockmarket rout which followed the bankruptcy of Lehman caused quite possibly the biggest global margin call markets have ever seen.

As usual, there are many unknowns which include how the economy will repond when taxes are raised (to bring the budget deficits back under control), how the economy will respond when the BoE starts to raise interest rates, etc, etc.

The real answer is that no-one knows if this is a new bull market or just a bear market rally.  In the early stages of an economic recovery we just have to take things one quarter at a time.  However investors should take some profits once they feel the stockmarket has discounted a recovery (whether one subsequently appears or not).  Markets often change direction around Labor Day and with the FTSE nearing 5,000 at the end of a summer rally (having closed at 5,416 the day before Lehman went bankrupt), this feels like a good time for the sensible investor to adjust the shape of their portfolio by taking some profits and moving some chips off the table.  Any combination of top-slicing or switching out of high beta shares (miners, insurers and banks) into defensives (utilities, food retailers and telecoms) seems to be the best course of action at this stage.