Sjp Economic Update Feb 2011

S PEC I A L I N V E S T M E N T B U L L E T I N

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Economic Update
February 2011
The final quarter of 2010 saw a revival in risk appetite as fears of a ‘double-dip’ recession faded. Equity markets
rallied on the back of better economic news as the lull in economic activity during the summer gave way to signs
of stronger growth in the world economy. Orders and output, as measured by the purchasing managers’ indices,
rose and retail spending in the US picked up.
Risk appetite also received a fillip from the introduction of further quantitative easing (known as QE2) by the
US Federal Reserve, with the US central bank announcing plans to buy $600 billion of US Treasury bonds by the
middle of 2011. Treasury yields fell sharply in anticipation of the move, driving investors into higher yielding and
more risky assets such as equities and commodities. Concerns that such action would result in higher inflation
over the medium term were also reflected in market expectations.
On a less positive note, the quarter also saw another crisis in the Eurozone, this time over Ireland, which led
to an €85 billion bailout at the end of November. However, after a brief pause, markets continued along their
upward path.

Performance of global stock markets during 2010
25

EURO STOXX 50 TR EUR (IN)
20 S&P 500 TR (IN)
Nikkei 225 CR (IN)
FTSE 100 TR (IN) 18.7
15 Hang Seng TR (IN)

10 14.8
Percentage growth

5
12.6
0

-5 11.7

-10
-5.4
-15

-20
01/10 02/10 03/10 04/10 05/10 06/10 07/10 07/10 09/10 10/10 11/10 12/10
365 days from 31/12/2009 to 31/12/2010

Source: Lipper Hindsight, data to 31 December 2010.

Please be aware that past performance is not indicative of future performance. Equities do not include the security of capital
characteristic of a deposit with a bank or building society. The price of units and the income from them may go down as well as up.

l 1


However, if any evidence were needed of the macroeconomic headwinds to come, this was provided in the form
of the January release of Gross Domestic Product (GDP) figures for the fourth quarter of 2010. This provided
a nasty shock in evidencing the UK economy was shrinking again following four successive quarters of growth.
Looking ahead, most commentators are expecting a modest, yet sustainable recovery with an upturn in corporate
profits providing the basis for stronger spending. As reported by Daniel Ben-Ami in the investor magazine, Fund
Strategy (10 January 2011) “If the many cash-rich large corporations in the western world start to invest in a new cycle of
expansion, that could make a big difference.” Lombard Street Research, an economic research firm, also expects
Britain to enjoy a “capex splurge in 2011”.
Goldman Sachs is forecasting global growth of 4.8% in 2011 and 5% in 2012, and in a marked change from 2010
they are anticipating growth to be far more evenly spread between the developed and developing economies. For
the UK specifically, they are forecasting growth of 2.4% in 2011 and 2.6% in 2012.

UK headline data
Gross Domestic Product (GDP)
After official figures showed that UK GDP – the broadest measure of economic activity – grew by 0.7% in
the third quarter of 2010, the coalition government and commentators in general were given a big shock when
the Office for National Statistics (ONS) revealed that the GDP figure for the fourth quarter of 2010 showed
the economy had shrunk by 0.5%, giving rise to the bizarre sight of the Chancellor of the Exchequer George
Osborne, attributing the fall to the weather. Yet the data shows broad-based declines across many sectors and is
a full percentage point below the consensus forecast of 0.5% growth. Some of the most dramatic falls were seen
in the construction sector which declined by 3.3% having provided support in the third quarter of some 3.9%.

UK GDP
8% £360bn
UK GDP, quarterly change, lhs UK GDP, quarterly change in recessionary years, lhs
UK GDP, annual change, lhs UK GDP, rhs
6% £330bn

4% £300bn

2% £270bn

0% £240bn

-2% £210bn

-4% £180bn

-6.0% £150bn
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Source: Office for National Statistics, latest data to 4th quarter 2010.

Vicky Redwood, senior UK Economist at research consultancy Capital Economics, said the data “did little to
improve the prospects for the economy in 2011”. However, she also noted that a breakdown of domestic demand by the
ONS now appeared more favourable, with a weaker contribution from government spending offset by a much
stronger one from investment.

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Mervyn King, Bank of England Governor, said the figures “demonstrated that the recovery was going to be choppy” but
dampened expectations of an interest rate rise to combat rising inflation.

Inflation
Consumer Price Index (CPI) annual inflation – the government’s target measure – hit 4% in January, up from
3.7% in December, remaining significantly above the Bank of England’s (BoE’s) inflation target of 2%.
Two of the main factors that had an impact on the January data were the increase in the standard rate of Value
Added Tax (VAT) to 20% and the continued increase in the price of crude oil. The largest upward pressures to
the change in CPI annual inflation between December and January came from:
Œ Fuels and lubricants: increases in VAT, fuel duty and in the price of crude oil all contributed to prices rising
between December and January by more than between the same months a year ago;
Œ Restaurants and cafes: the increase in VAT contributed to prices rising by 1.4%, which equals the record
monthly increase;
Œ Alcoholic beverages: prices overall rose by 6.7%, a record monthly increase;
Œ Furniture and furnishings: prices fell by less than usual between December and January. The smaller fall was
partially a consequence of certain major retailers not increasing their prices as much as usual in December
in the lead up to the New Year sales. Price reductions in the January sales were therefore, not as significant
as usual;
Œ Purchase of vehicles: prices for both new and second-hand cars rose this year between December and January
relative to a year ago (source: Office for National Statistics, latest data to January 2011).
In the year to January, Retail Prices Index (RPI) annual inflation (which includes housing costs) was 5.1%, up
from 4.8% in December.

UK inflation
7% 7%
UK Base Rate UK CPI In ation UK RPI In ation
6% 6%

5% 5%

4% 4%

3% 3%

2% 2%

1% 1%

0% 0%

-1% -1%

-2% -2%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Office for National Statistics, latest data to January 2011.

As an internationally comparable measure of inflation, the CPI shows that the UK inflation rate in January was
above the provisional figure for the European Union (EU). The UK rate was 4% whereas the EU’s as a whole
was 2.5%.

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Mervyn King said rising inflation was the biggest threat for the Bank’s Monetary Policy Committee (MPC),
warning it would rise to “somewhere between 4% and 5% over the coming months”. Inflationary pressures look set to
continue throughout 2011, as upward pressure persists on global commodity prices, food, clothing and fuel.
At home, VAT and other taxes have added to public sector fees and charges to provide a further twist to the
inflationary spiral.
The source of inflationary pressures and the headwinds facing the UK economy are creating conflicting pressures
for the MPC in their deliberation over if and when to raise interest rates from current historic lows. There is
a clear split between their commentators arguing for an immediate increase in interest rates to choke-off any
inflationary pressures and those in the other camp arguing that increased interest rates could prove fatal to any
economic recovery, whilst doing little to impact on rising fuel and commodity prices.

Employment
Latest figures released by the ONS in February show unemployment remaining stubbornly high at 7.9%. The
total number of unemployed people increased by 44,000 over the quarter to reach 2.49 million.
Figures also evidenced that the employment rate for those aged 16 to 64 for the three months to December 2010
was 70.5%, down 0.1% on the quarter, whilst the number of people in employment aged 16 and over fell by
68,000 on the quarter to 29.12 million.

UK employment
13.0% 74.0%
UK unemployment rate %, lhs UK employment rate %, rhs UK employment rate in recessionary years, rhs
12.0% 73.0%

11.0% 72.0%

10.0% 71.0%

9.0% 70.0%

8.0% 69.0%

7.0% 68.0%

6.0% 67.0%

5.0% 66.0%

4.0% 65.0%
1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Source: Office for National Statistics, latest data to December 2010.

House prices
The average cost of a home in England and Wales dropped by 0.5% in January to stand at £153,600 – 2.2% lower
than in January 2010, according to housing intelligence firm, Hometrack. Potential buyers continued to sit on
their hands in the face of house price falls, and uncertainty over the economy and future interest rate rises.
Estate Agents reported a further 9.5% fall in the number of people registering properties with them, the seventh
consecutive monthly decline, contributing to a 26% fall in demand over the past six months.

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The weakness of the housing market has been further compounded by a lack of mortgage availability, which
is deterring buyers. Recent figures from the BoE show that in the last quarter of 2010, lenders have seen the
biggest drop in demand for loans from homebuyers since the third quarter of 2008, pointing to continuing falls
in valuations into 2011.
Richard Donnell, Director of Research at Hometrack said “There are no signs of an early bounce for the housing market
in 2011, as the year has begun sluggishly.”

Wider economy
Whilst the outlook for the global economy remains uncertain, global economic growth has proven to be quite
resilient, notwithstanding recurring sovereign debt crises in Europe, the chronic housing-related and debt
problems facing US households, and the potential destabilising impact on the global economy and commodity
markets from the reining in of credit conditions in the higher-growth, inflation-prone emerging economies.
Other important developments, such as geopolitical and weather-related problems, may temporarily dampen,
but have not derailed expansion. Public policy remains quite accommodative and along with improved business
confidence and spending around the world, is supportive of global growth.
The sustainability of global growth is being reinforced by the continuing gains in manufacturing activity,
improving credit conditions, and expanding international trade. In Europe, Germany’s economy has continued
to gain momentum, with its highly competitive export-oriented transportation and equipment sectors piggy-
backing on accelerated industrial growth around the world, and more recently, increased domestic business and
consumer activity. This strong performance has provided important support to the region’s peripheral nations
undergoing unprecedented fiscal compression.
On the other side of the Atlantic, another round of fiscal stimulus has pumped up US consumer spending,
reinforcing the cyclical dynamics of increasing business activity, including expanded production, investment and
profitability. The Fed also appears likely to keep interest rates low in order to keep the recovery on track despite
recent improvements in the macro news and expectations of stronger growth in 2011.
Over in the emerging world, monetary policy is expected to tighten more rapidly in response to inflationary
pressures and concerns about asset bubbles. China is forecast to raise interest rates further through 2011 and allow
further modest appreciation of the remnimbi. However, there remains a considerable backlog of production,
construction, and development activity that is reinforcing consistently strong growth numbers.

Impact on financial markets
Markets around the world, led by the US, have continued to make strong gains over the last three months. The
exception to this was Hong Kong, where the Hang Seng has fallen by 8%, as investors trained their attention on
Asian inflation.
Stocks rallied strongly in anticipation of a second round of QE and fiscal expansion in the US. At the same time,
both US and Japanese equities found support from upward surprises on the macro front, with Japan also seeing
strong capital flows in recent weeks, despite its sovereign debt rating being cut by Standard & Poor’s from AA
(with a negative outlook) to AA- on concerns that the government is not doing enough to tackle its $11 trillion
gross debt burden.

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Performance of global stock markets over the past three months
12.5

EURO STOXX 50 TR EUR (IN)
S&P 500 TR (IN)
10.0
Nikkei 225 CR (IN)
FTSE 100 TR (IN) 9.9
Hang Seng TR (IN)
7.5

5.0 7.4
Percentage growth

2.5
7.1
0.0

-2.5 4.2

-5.0
-7.9
-7.5

-10.0
12/2010 01/2011 02/2011

91 days from 11/11/2010 to 10/02/2011
Source: Lipper Hindsight, data to 10 February 2011.

Please be aware that past performance is not indicative of future performance. Equities do not include the security of capital
characteristic of a deposit with a bank or building society. The price of units and the income from them may go down as
well as up.

In the US, there was a clear trend of cyclicals outperforming the more defensive sectors. In particular, cyclical
stocks in the consumer discretionary and material sectors stormed ahead of their defensive peers such as
healthcare and utilities. Meanwhile, the style winners were small cap and growth stocks. By comparison, value
stocks were dragged down by the poor returns of financials, as underlying revenue growth was negative for
most banks.

What to expect in 2011
United States
“Corporate cash balances remain healthy... and should be strengthened by continued
profitability” (Keith Wade, Chief Economist & Strategist; Schroders).
The Obama administration has recently announced further fiscal expansion via the extension of tax cuts and
unemployment benefits. Another bright spot is the US corporate sector where firms continue to maintain
strong cash balances, which should lead to increased capex spending, buybacks and M&A (mergers and
acquisitions) activity.
There are already signs of improvement in M&A activity, indicating growing corporate confidence. In particular,
US corporate earnings are expected to outpace GDP growth, as the profit share edges higher.
From a valuation perspective, the US appears attractive relative to history with analysts continuing to revise
up their earnings expectations for US equities, such that it has become one of the markets with the strongest
outturn of stock upgrades.

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United Kingdom
The UK still faces significant fiscal challenges ahead given the spending cuts on public services in 2011. However,
whilst this fiscal squeeze is likely to drag on economic growth short-term, over the longer-term such policy
should free the private sector from the shackles of state intervention.

Tim Steer, Fund Manager with Artemis Investment Management remains confident
on the future for the UK economy and UK equities in general – “Our currency is
independent, our economic policy can be adjusted to suit our circumstances and
our debt is long maturity, so less likely to be bullied by financial markets. The
valuations of many UK domestic stocks are low and attractive, and many companies
are flush with cash.”
This is a view supported by George Luckraft, Fund Manager at AXA Framlington
– “Broadly speaking, the environment remains positive for UK equity income
investors, with opportunities not limited to large-cap stocks. While mid-caps
benefited from M&A activity in 2010, many smaller companies with similar
characteristics, or in related sectors, are now on lower ratings. This provides good
scope for potential catch up gains. Identifying attractive valuation, regardless of
size, will drive investment returns.”
It should also be recognised that the FTSE 100 companies are less geared towards the domestic economy,
instead benefiting from overseas growth and earnings, with foreign income representing approximately 60% of
their total income. Consequently, consensus earnings expectations on the market are looking relatively upbeat
versus elsewhere.

Europe
The weakest growth outlook in the developed world is to be found in the Eurozone given the region’s structural
debt issues and the impact of fiscal consolidation. Going back to the beginning of last year, the euro was weakened
by the re-assessment of the solvency of the peripheral economies. Nevertheless, the valuations of the market in
aggregate, together with strong corporate cash-flows, mean equities appear an attractive long-term prospect,
particularly relative to bonds; a view held by Paras Anand, Economist at F&C.
GDP in the Eurozone expanded by 0.30% in the fourth quarter of 2010 compared to the previous quarter
(source: Eurostat, statistical office of the European Union). However, there is disparity between the individual country
economies; while the domestic landscape in peripheral Europe looks relatively bleak, core countries such as
Germany are experiencing a strong resurgence in their economies.
Thomas Straubhaar, Director of the Hamburg World Economics Institute recently reported “Germany is experiencing
a new economic miracle. Unlike the UK and Ireland, which have shifted to services and especially finance and capital markets,
Germany has remained an industrial nation.” In addition to a shrinking budget deficit of 3.9% (compared to 6.3%
across the Eurozone), Germany is running a 5% current account surplus and unemployment has just hit an
18 year low (source: Eurostat, statistical office of the European Union).
Europe also boasts some highly-respected global companies including Allianz Worldwide, DaimlerChrysler,
Deutsche Bank, Mercedes Benz, BMW, Nestle, Novartis, Syngenta, EDF and Christian Dior to name a few. “These
are robust companies with strong cash-flows suggesting equities remain attractive over the long-term” added Mr Straubhaar.

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Japan
The exchange rate has recently stabilised and a weaker yen could spur equity gains given the importance of
exporters to the market. Japan is also not as directly impacted by developments in the Eurozone. This in turn
should be a welcome relief to exporters given the important role they play in the performance of the market.
Historically, Japan tends to benefit from cyclical improvements in the US economy when there is a rise in monetary
tightening expectations. This is indicative of the strength in the global economy and demand for exports.
However, Japan’s economic outlook remains bleak, with commentators forecasting a period of continuing
stagnated growth. As Hugh Young, Managing Director of Aberdeen Asset Management (Asia) says “It is right
to continue to be underweight Japan. Simply put, it is difficult to envisage a scenario in which Japan’s corporate sector does
better than the rest of Asia’s over the next decade.” This bearish outlook rests on two main premises. First, economic
growth in Japan will continue to stagnate. Second, other countries in Asia have better growth prospects. While
the causes of stagnation are complex, the symptoms are obvious; real GDP growth has averaged just 1.1% a
year since 1991.

What is stagnation?
Stagnation is a period of little or no growth in an economy. Economic growth of less than 2% a year is considered stagnation.
Stagflation is the situation when both the inflation rate and unemployment rate are persistently high – this is a complex
situation for a government because when inflation and economic stagnation are occurring simultaneously, a policy dilemma
results since actions that are meant to assist with fighting inflation might worsen economic stagnation and vice versa.

Despite this, there remain commercially well-run companies, albeit, in the opinion of Hugh Young, they remain
the exception rather than the norm – “These are the companies that compete globally and whose fortunes are tied more to
the growth of the emerging world than the mother country.”

Asia Pacific ex Japan
Asia Pacific ex Japan should continue to respond well to benign liquidity conditions due to loose monetary policy
and fiscal expansion in the US. Nonetheless, for countries such as Hong Kong and Australia, close ties with China
means that further policy tightening could hamper market returns.
Equity markets have had a volatile start to the year, as investors have trained their attention on Asian inflation
and policy tightening. The Peoples’ Bank of China only recently raised benchmark interest rates, the third such
increase since October, as Beijing intensifies its battle against stubbornly high inflation.
The benchmark one year lending rate was raised 25 basis points to 6.06%. “For China, the year of the rabbit is the
year of inflation”, said Qu Hongbin, Greater China Chief Economist at HSBC. “Given that growth is still strong, Beijing
can now fight against inflation single-mindedly.”
Despite policy tightening, solid economic fundamentals and positive structural trends look set to sustain Asia
for many years to come. “One such trend is urbanisation – in our opinion the most powerful driver of economic development
and equity market returns in Asia over the next 5-10 years” said Edward Stileman of J O Hambro Capital Management.
He added “Investors should look through the next few months of potential volatility. Asian equities are reasonably valued on an
historic and relative perspective. With abundant global liquidity and solid fundamentals, they will not remain so.”

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Emerging markets
“The best sustainable growth prospects remain in the emerging world due to their
stronger structural fundamentals, however, their growth premium is more reflected
in equity valuations” (Keith Wade, Chief Economist & Strategist; Schroders).
Unsurprisingly, one of the key contributors to emerging growth is expected to be China, which is forecast to
expand by 9.5% and 9.7% respectively in 2011 and 2012 (Source: Scotia Economics – 3 February 2011). However,
their growth premium is now more reflected in equity valuations and investors’ sentiment towards the region
has cooled.
Emerging markets have had what could be called a ‘good crisis’. While the economies of the developed world
have largely struggled since the dark days of autumn 2008 and the collapse of Lehman Brothers, the economies
of the developing world have been resilient. Emerging market equities have enjoyed a super-charged run since
2009, surpassing returns in developed markets over the last two years and sucking in speculative flows of money
at a frantic rate.

Performance of emerging markets over the last two years
110

100 MSCI EM (Emerging Markets) TR GBP (IN)
FTSE 100 TR (IN)
90
S&P 500 TR (IN)
80
84.5
70
Percentage growth

60

50
53.1
40

30

20
47.7
10

0

-10

-20
04/2009 07/2009 10/2009 01/2010 04/2010 07/2010 10/2010 01/2011

729 days from 11/02/2009 to 10/02/2011

Source: Lipper Hindsight, data to 10 February 2011.

After such a stellar performance, 2011 may well be marked by a switch in market leadership towards developed
markets. Rather than being propelled purely by fundamentals, emerging markets have been fuelled by QE in the
US and the push to devalue currencies in the West.
Despite this more cautious picture for 2011, rewarding opportunities will still abound for the disciplined stock-
picker. “Areas we find appealing include South Korea and Taiwan, where export-oriented technology stocks look well placed in
view of the nascent US economic recovery” reported Emery Brewer of J O Hambro Capital Management. “Elsewhere in
the world, we can still find numerous stocks offering compelling growth opportunities, in countries such as Turkey.”
While emerging markets may take more of a back seat to developed markets in 2011, and continue to experience
high levels of volatility, good stock-picking should still enable investors to tap successfully into the dynamic
growth of the developing world.

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The five threats to the continuing global recovery
Chinese policy mistakes
Chinese economic growth has been strong in 2010 and more of the same is expected in 2011, despite recent
moves to rein in bank lending and stymie speculation.
The FTSE 100 has benefited greatly from its exposure to the economic success of the world’s powerhouse,
with 70% of large UK companies exposed to China while cheap prices for Chinese imports are a key factor in
household budgets. However, the recent surge in Chinese inflation has sparked fears about how the rate-setting
Peoples’ Bank of China will respond. Inflation soared above 5% in November – well above the bank’s 3% target
but still well below the all-time high peak of 8.7% in February 2008.
There are worries that recent policy moves in the US, including the decision to extend the ‘QE2’ programme
of bond buying and to extend tax cuts and unemployment benefits, could impact on the Chinese situation. If the
measures in the US do stimulate growth, it could lift metals and oil prices, adding to inflation across the globe
as Chinese manufacturers will have to lift the price of their exports. However, if Chinese authorities respond by
continually lifting interest rates, which recent events suggest they will, that could also potentially slow growth
there and have a dramatic impact on demand for raw materials and the FTSE.
A key focus in 2011 will be whether China will finally bow to overseas pressure and allow the value of the Chinese
currency (the yuan or remnimbi) to rise – which could also hamper the country’s export-driven growth.

Banks
‘If lending remains at the current levels, businesses could struggle to finance
expansion and will struggle to expand’ (Deborah Hyde; Citywire – 4 January 2011).
The uncertain economic backdrop could cause problems for banks both in the UK and abroad in 2011. In 2010,
banks have mostly fared fairly well, with shares in Lloyds and RBS finishing the year around 30% higher than
where they started, and only Barclays and HSBC shareholders sitting on losses.
However, any rise in unemployment always increases the risk that more borrowers will fall behind in their
payments and this makes banks nervous about lending. “If lending remains at the current levels, businesses could
struggle to finance expansion and will likely struggle to find ways to expand” reported Deborah Hyde in Citywire.
In response, the government revealed new rules on tackling bankers’ bonuses and bank lending; Project Merlin
was announced by the Chancellor, George Osborne to the House of Commons in February.
RBS, HSBC, Lloyds, Barclays and Santander have committed to making available £190 billion of credit to
businesses in 2011, with £76 billion being made available to SMEs (small and medium sized enterprises). Even
though the BoE will monitor whether such funds are ultimately made available, some economists and politicians
questioned the benefits. Shadow Chancellor, Ed Balls accused the government of “putting politics ahead of economics.
For the Chancellor who talked so tough in opposition... this is a pitiful outcome and an embarrassing climb-down”. He added
“the banks won’t be forced to lend if they don’t want to.”
Against this backdrop the banking sector faces further obstacles in 2011. Clare Spottiswoode, a member of the
banking commission charged with improving competition in the sector, has already warned that Lloyds could
be forced to sell HBoS. The commission is due to make an initial report in April and final recommendations in
September. Uncertainty over how the government will disentangle itself from its 83% holding in RBS and 41%
holding in Lloyds could dog shares.

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Overseas worries could also cause pressure on UK markets, with analysts talking about the risks from everything
from a Wikileaks exposé on Bank of America to the ongoing US sub-prime scandals, or the stress tests in Europe.

What are stress tests?
Stress tests are the equivalent of a health-check for banks and following the financial crisis, the Committee of European
Banking Supervisors (CEBS) has carried out such tests on European banks, with the promise of more to come in 2011. The
ultimate purpose of the test is to ensure banks have the ability to withstand future financial shocks, such as a ‘double-dip’
recession, by holding sufficient levels of capital relative to lending (capital ratios).

European debt
With Europe promising more rigorous stress tests for the sector in 2011, there is always a risk that European
debt worries, which have been largely contained at the end of 2010, will begin to spill over to other markets and
into the wider economy during 2011.
For now, most commentators believe the economy in Spain is much stronger than in Greece or Portugal, making
a bailout unlikely. Yet with the interest rates being charged to governments creeping higher, not all experts are
convinced that a rescue is completely out of the question.
Ireland’s bailout was sparked by concerns about its banking system and UBS Analyst Bosco Ojeda said he believed
there could be similar problems in store for Spain.
Most analysts believe the European Central Bank (ECB) will be reluctant to pledge large sums to its programme
to buy government bonds. It is also thought that Europe’s political leaders will only agree to hand over more cash
if the market forces them to. As a result, analysts fear that market worries could force a Spanish bailout and that
could begin to take its toll on global markets and potentially world trade during 2011.

US debt
While it is no secret that many European governments are in debt and need to do more to address their problems,
it is also becoming increasingly clear that the US has troubles of its own. As of 31 January, the total public debt
outstanding was $14.13 trillion and was 96.4% of 2010’s annual GDP of $14.7 trillion (source: US Budget (historical
tables) at whitehouse.gov/omb).
Despite the US Administration announcing plans to reduce the deficit in the 2011 Budget, it has also committed
to extending Bush tax breaks and increasing spending on unemployment benefits. That will add to the deficit
problem in the years ahead and has already sparked worries amongst investors.
With data towards the latter part of 2010 and early 2011 suggesting the US economic recovery is now on a solid
footing, multiple factors are lifting the interest rates the US government has to pay on its borrowing and have
sparked concern about what would happen if rates jumped to 5%, especially since the country’s debt is likely to
continue to climb in the years ahead as healthcare and pension payments rise.
Researchers at the IMF have said that if these high levels of debt become ingrained it could limit growth in the
world’s largest economy. There is an outside chance that these worries could begin to weigh in the latter half of
2011 and unsettle markets across the world.

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UK inflation
‘Many forecasters... have now predicted interest rates will rise by around 1% over the
next two years’ (Deborah Hyde; Citywire – 4 January 2011).
The current levels of high inflation are already a problem and inflation is expected to rise further in 2011 as the
20% VAT increase and higher oil prices take their toll further. The governor of the Bank of England has also
hinted at inflation reaching a level of between 4% – 5% in the coming months.
Chinese and American policies could also add to upwards price pressures and that could mean the BoE’s rate-
setters will not be able to bring inflation down to more acceptable levels without lifting interest rates. Indeed, in
the last few weeks of 2010 and early 2011, many experts began to revisit their forecasts and have now predicted
interest rates will rise by around 1% over the next two years.

What is an interest rate ‘swap’?
An interest rate ‘swap’ is an agreement between two parties (known as counterparties) where one stream of future interest
payments is exchanged for another based on a specified principal amount. Interest rate ‘swaps’ often exchange a fixed payment
for a floating payment that is linked to an interest rate (most often the London Interbank Offered Rate – LIBOR). They will
typically be used to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than
it would have been able to get without the ‘swap’. An increase in the 5 year rate means that money markets have priced in such
an increase in anticipation of an interest rate rise.

Money markets have recently priced in an increased likelihood of base rate rises after several sets of exceptionally
strong industry figures. The 5 year interest rate ‘swap’ surged from 2.92% to 3.24% on 7 February before easing
back a little to 3.16%. The futures market regards an interest rate rise by May as essentially a ‘done-deal’.
Members of the MPC have already said inflation is likely to be above target for most of 2011 and are currently
split about what needs to be done. One member, Adam Posen, says more stimulus is needed, while Andrew
Sentance and Martin Weale both believe a small interest rate increase is necessary to reassure people that the
BoE has got its eye on the ball.
With the latest GDP figures evidencing that the UK economy is shrinking, most economists suspect the BoE will
sit tight over the next few months and this could strengthen inflationary fears short term.
With hundreds of thousands of civil servants set to lose their jobs in 2011, as a result of the government’s
austerity measures, it is essential that the private sector feels confident about taking up the slack. Not keeping
inflation in check could jeopardise that and could stop consumers spending.

Conclusion
With the macro-economic headwinds blowing our way and the economic recovery looking under threat or at
best anaemic, it is worth taking on board the views of a number of our Fund Managers.
Richard Peirson of AXA Framlington provides an economic and market overview:
“While overall GDP growth is likely to be lower in 2011 as impetus from restocking fades, activity is anticipated to remain
healthy. Further signs of improvement in the major economies of the US and parts of Europe highlights the broadening nature
of global growth.

l 12


We continue to expect monetary policy to remain ultra loose in the developed economies, due to large output gaps remaining in
many economies, further quantitative easing in the US and ECB support for Southern Europe. For many emerging economies
rising inflationary pressures are likely to result in a further tightening of monetary policy.
The economic backdrop combined with a loose monetary policy continues to provide a supportive backdrop for equities. European
equities remain attractive compared to long term valuation averages and on a relative basis to other equity markets.”
Meanwhile, Neil Woodford of Invesco Perpetual had this to say about current market conditions in the UK and
the opportunities these present:
“We believe that current market conditions offer the opportunity to invest in quality growth companies that are profoundly
undervalued.
We are cautious on the outlook for the UK economy and as such are attracted towards businesses that have strong fundamental
characteristics; a sound balance sheet, resilient and transparent earnings, and the potential to deliver sustainable dividend
growth.
At the current time, we believe that companies in the tobacco, pharmaceutical, utility and aerospace sectors fulfil these criteria
and many also earn a significant part of their revenues overseas, which reduces the fund’s reliance on domestic economic
conditions. As the challenges that still face the economy become increasingly apparent, we believe these companies will regain
their traditional premium to the market.”
The views of both fund managers and economists vary greatly, which historically has always been the case.
On the one hand there are the ‘bulls’ pointing to attractive valuations, renewed M&A activity and the strong
balance sheets of companies, whereas on the other there are the ‘bears’ focussing on UK economic contraction,
fiscal tightening and recent political unrest in Egypt. The only thing which can be said with certainty is that
uncertainty remains in both the UK and globally. It is equally important to remember that financial markets do
not always move in tandem with economic data. Financial markets will typically move in advance of economic
news and are driven in the main by investor sentiment. On this basis St. James’s Place remain of the view that
clients should hold a well diversified portfolio of both asset classes and fund managers appropriate to their risk
profile, with an aim of achieving capital growth over the medium to long term.

The views and opinions of the analysts and fund managers quoted, are not necessarily those held by
St. James’s Place Wealth Management.

Members of the St. James’s Place Wealth Management Group are authorised and regulated by the Financial Services Authority.
The St. James’s Place Partnership and the title ‘Partner’ are the marketing terms used to describe St. James’s Place representatives.

AM522
l
St. James’s Place UK plc: Registered Office St. James’s Place House, 1 Tetbury Road, Cirencester, Gloucestershire, GL7 1FP, United Kingdom
Registered in England Number 2628062

www.sjp.co.uk
13 SJP3476-VIR1 (02/11)

Sjp Economic Update Feb 2011

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