UK’s Latest Import - Inflation

Rob Mackrill - Fri 11 Apr, 2008

The weak pound is importing inflation and wages are starting to rise.

Yesterday, UK rates came down a quarter to 5%. ECB rates held steady as expected at 4% and all of us who continue to feel poorer can be grateful that we’re not paying a mortgage in Iceland. There a surprise upward move has taken rates 50bps higher to 15.5% as they try to cool inflation near 9% and prop up their sickly currency, the krona.

What did the markets make of these monetary decisions? Not much. European stocks, as measured by the Eurofirst 300, closed down 0.4%. The FTSE 100 was down 0.3%. Again, be grateful if you didn’t invest in Icelandic stocks. The Icelandic index, two-thirds of it bank stocks, is down 80% over one year!

“Banks minor cut offers little respite,” says the FT headline of the UK cut. “We haven’t had enough of a slowdown to give the Bank carte blanche to cut...”, says Deutsche Bank economist George Buckley. Not yet, at least, but the consensus has it that the base rate trend is down. A stance of little help to those with mortgage rates which are moving quite regularly the other way. But then we’ve gone from feast to famine in the mortgage market within a year.

In the battle to keep a lid on inflation, the currency markets are backing the European Central Bank’s Teutonic inspired determination over that of their more flaky Anglo-Saxon rivals. The euro touched a new record yesterday against both the US dollar ($1.5912) and the pound (80.29p). It’ll buy 115 Icelandic krona too, against 92 at the start of the year.

The Chinese currency is also on the move. The renminbi broke 7 Rmb to the dollar, its highest level since revealing and breaking its dollar peg in 2005 as its reveals foreign exchanges reserves have climbed to near $1.7trn.

In the interbank market, the Libor rate has held steady at 5.92%.

Aside from the prospect of a dearer holiday for Brits travelling on the continent this year, a weak pound adds fuel to the inflation problem. “Import price inflation reached a 14-year high in February as the weaker pound drove up the cost of imported goods,” reports the FT. The annualised rate, according to government statistics, is in double digits at 10.4%. A further worry is that UK wage settlements are starting to go up too. Median pay was up 3.5% in the first quarter but two-thirds of settlements in April are “at or above 4%,” according to Incomes Data Services.

Elsewhere, another day another housing market survey. The FT Acadametrics survey bases its read on all property transactions in England and Wales. It reports “static prices” in March, with annualised growth continuing to trend down. Now 5.4% from 6.1% in Feb. It’s a picture that looks set to continue for the time being, but the fundamentals of supply and demand, employment and interest rates continue to be favourable says statto-in-chief, Acadametrics chairman, Dr Peter Williams. He adds:

“Although expectations seem to be set for widespread falls in actual house prices, the facts remain that demand continues and mortgages are still being supplied in volume reflecting the relatively strong economy. The next few months will be critical in terms of likely outcomes with much turning on the part played by the Bank of England.”

*** For all our sophisticated technology, it’s back to basics for investors. Agriculture is the place to be, says Eclectica asset management. It makes the investment case:

The real cost of food has been declining for 35 years; the world’s population has been growing by 1.5% pa; land has been lost to water shortages and urbanisation; supply has been lost to subsidised biofuels; emerging economies are drives demand for land intensive protein and dairy products and for eight of the last nine years the world has consumed more food than it has produced. More on why food prices are going up from Bill below.

*** The axe is about to swing at the investment banks. Next week cuts are expected to begin, reports efinancialcareers.co.uk, with the biggest cuts expected from the biggest losers in the subprime adventure – Citigroup and UBS. 10,000 plus are forecast in toto. Sounds bad, but it could be worse, says Andrew Burrell, chief economist at Experian. Back in the ‘90s 50-60,000 jobs went and back then (when few had heard the word ‘derivative’) the financial community was a fair bit smaller. Adding:

“Right now we don’t have the wider economic context of a UK-wide recession to create job cuts of that magnitude”

*** Colleague Theo Casey reports on a multi-billion dollar worry for alpha bankers Goldman Sachs following a recent disclosure:

"On Wednesday Goldman was the first US bank to show its hand. The results were worse than expected.”

"The world’s most profitable investment firm reported that its hard-to-value securities, so called Level 3 assets, jumped almost 40% from $69.2bn to $96.4bn. “

"There are three asset types to know when divvying up investment bank balance sheets:

** Level 1 assets are valued by available market prices in active markets. These include stocks, futures and options.

** Level 2 assets are priced using "observable inputs,'' which means recent similar transactions. Loans, mortgages and over-the-counter stocks fall into this category.

** Then there's Level 3. These assets are measured using "unobservable inputs," and it’s as bad as it sounds. It means that even though the firms can’t actually see the value of their assets, they're allowed to put them down as earnings based on their own "subjective assumptions." In other words, they guess.

"When you hear the BBC News refer to "subprime-related" losses, what they mean is Level 3 assets that couldn’t be shifted. The world’s most profitable investment bank, we found out on Wednesday, has rather a lot of them.”

"So it just got 40% harder to value Goldman Sachs. That’s because it involves guessing what the bank will fetch for its Level 3 assets, which has proven to be a market that no one wants to be in.”

As to commercial banks, we came across this revealing little table of pre-crunch UK banking funding (end of June 2007) courtesy of Morgan Stanley:

Presumably the Financial Services Authority had this kind of information, yet paid fewer visits to the Rock than the other banks. As our US colleagues would say: Go figure! The full table click in this link (page 124).

Regards,

Rob Mackrill
The Daily Reckoning