Economic recovery is a slow and painful process

With the news that other major economies are out of technical recession, can we dare to dream that good times are just around the corner for the UK?

One finance director who ought to know is Ray Doughty from FD Solutions, a team of FDs who support businesses struggling to keep on top of their finances.

“General upbeat company news has led to greater confidence in the stock market ­ major companies that provide value seem to be doing well currently,” he says.
So break open the champagne, then?

Keep it on ice for a while longer. “The UK’s economic recovery will be fragile,” says Simon Kirby, an economist at the National Institute of Economic and Social Research (NIESR). Joe Nellis, professor of international management economics at Cranfield School of Management, agrees that the UK economy “will have a bumpy recovery next year.” Patrice Muller, a partner at London Economics, adds that he expects modest growth to recover in the UK and North America, while it will be stronger in continental Europe ­ putting the pressure on any government for the latter half of 2010.

Muller believes we will see anything from 2% or 3% GDP growth in the UK and North America and from 3% to 3.5% in Europe between the last quarter of 2009 and the same time in 2010. “Asia will power ahead and China will continue to lead the pack,” he says.

Nellis is less optimistic, predicting GDP growth of 1% or 2% in the UK and around 1.5% in Europe. “But the US looks set for a solid rebound ­ perhaps growth of as much as 3.5% in 2010,” thinks Nellis. “Asia is already showing signs of growth with China and India back to pre-crisis rates of between 8% and 9%.”

With consumer spending still depressed, how is the UK going to stimulate some growth in 2010? “Economic recovery is dependent on the contribution of net exports and in that sense, is dependent on the recovery of the major eurozone economies and the US,” says NIESR’s Kirkby.

“A rapid recovery in these economies would drive recovery in the UK.”

He adds, though, that any quick return to inventory accumulation would come at the expense of economic growth in 2011 as the greater issue for sustainable growth is the indebtedness of household balance sheets, which a focus on driving inventory would put at risk of being overlooked. “We do not expect the recovery to be driven by UK consumers, but there is a risk that consumption growth could return,” says Kirkby.

Double-dip
What about the threat of the dreaded double-dip recession? London Economics’ Muller doesn’t buy it as a credible option. “There are no signs of an impending double-dip recession ­ no inventory overhang,” he says. “While it can’t be completely ruled out, the probability is relatively low. Much more likely is a gradual, but sluggish recovery, with growth picking up only in the second half of 2010 in the US and UK.”

Muller’s view remains contrary for many. “I firmly believe we are in for a double-dip recession,” says Kevin Dickens, president of the UK200Group of accountancy and law firms. “The recent recovery in the stockmarket was fuelled by massive injections of public cash into the banking system, a desperate need for the public and investors to hear some good news and the tiny returns on cash savings. I moved all of my pension pot into cash funds a couple of weeks ago. My clients are telling me that business, both on the high street and in what we have left in our manufacturing industry, is slow - and not gaining momentum.”

With that massive budget deficit hanging over our heads, is there no alternative to painful public spending cuts in the next year and well beyond?

“The main obstacle to economic recovery will be the inevitable squeeze on government spending and tax rises,” says Nellis. “These cannot be avoided.” As most concur, Tony Nash, area director of large corporate markets at Lloyds Banking Group, believes the level of public debt can only be tackled with tax rises and cuts in public spending.

Professor Mariana Mazzucato, who holds the chair of economics and innovation at the Open University, believes growth in the next two years will depend on the ability of the financial system to restructure itself “so that it nurtures those companies willing to undertake risky technological and organisational experimentation ­ potentially leading to new products and processes, the foundation of long-term growth,” she says. “The current signs are not so encouraging on this front, so a harsh wake-up call is needed if we are to achieve growth in 2010.”

Of course, companies need cash to execute research and development ­ and for many this means bank finance, which, as we know, has been frozen for some time. But in recent months, the story has evolved as businesses have begun to count it out as an option and find other ways. Banks are now focused on lending only to the strongest businesses with the most experienced teams ­ in other words, they’re risk averse ­ and this is not likely to change in 2010.

“We remain focused on supporting experienced management teams with credible business plans. We are very keen to support both new and existing clients’ investment plans and in these economic conditions, opportunities will arise, such as investment in technology to reduce costs and the purchase of under-managed businesses,” says Lloyds Banking Group’s Nash.

But Professor Ismail Erturk, senior fellow in banking at Manchester Business School Worldwide, believes confidence is the biggest factor in whether businesses want to invest or not.

“The problem is that companies don’t wish to borrow and invest because the economic outlook is bad. Fiscal policy in the form of tax cuts may play a greater role in economic recovery ­ ultimately, what is needed is public expenditure but governments have big deficits and cannot do this,” he says. “I don’t think industry will carry out investments if the economic outlook looks bad. SMEs suffer from bank lending restraints, but big corporations have access to capital markets.”

Will a potential change in government be a good thing, a bad thing, or make no difference to the level of public spending cuts that seem inevitable?

Cranfield’s Nellis says it won’t change the inevitability of a squeeze on government spending and increase in taxes, though a Conservative government “is likely to seek cuts in some of Labour’s more social-orientated programmes.”

NIESR’s Kirkby thinks the scale of the structural deficit means that a combination of cuts to expenditure plans, tax increases and the bringing forward of planned increases in the state pension age may be the best approach to reducing the structural deficit. Even though most are convinced (or resigned) to the fact that the UK will see the Conservatives triumph in 2010, Doughty doesn’t agree.

“The Conservatives have to win too many seats and to do so they have to convince the public that their policies are significantly different from Labour. All at a time when there will be sufficient improvements in the general economy ­ thus making Labour’s position relatively secure.”

And interest rates are likely remain low encouraging companies to borrow ­ right?
Right. “Short-term interest rates are unlikely to rise much, if at all,” predicts Cranfield’s Nellis. “Given the increase in quantitative easing announced by the Bank of England in November, we can expect the base rate to remain low for the next year or so. Long-term interest rates are likely to edge upwards as the government sells more bonds to fund its deficit ­ which will place upward pressure on the cost of capital for business investment.”

London Economics’ Muller is less sanguine. “Policy interest rates in Europe are likely to rise gradually starting in the first half of 2010, in line with the earlier recovery in continental Europe,” he suggests. “In the UK and US, this upward movement is likely to be delayed until the second half of 2010. Long-term rates, however, will most probably increase much sooner, reflecting financial markets’ fears about future inflation due to a delayed unwinding of the massive central bank liquidity injections.”

The FTSE-100 rebounded recently but some think this a false dawn and a dangerous contributor to a sense of confidence in recovery that is not merited. “Stock markets reach the bottom of their performance before the real economy and tend to be at a 30% premium to their lowest point, at the time when the recession in the real economy is deepest,” says Williams, managing partner for the UK and Ireland at Ineum Consulting.

“The stock market is driven by confidence and a few shocks ­ maybe more bad news from banks, maybe a collapse of a major corporate under debt burden ­ will probably hit the markets very heavily. Of course, some sectors with resilient revenues will likely do well out of the current environment.” Those sectors could include renewable energy, pharmaceuticals and life sciences, suggests Dave Lemus, chief financial officer at MorphoSys, a biotech company.

Return to dealflow
Kraft’s stalking of Cadbury suggests there could be some battles among the titans ahead.

Will we be back in M&A land in 2010?

“We are seeing a gradual improvement in the M&A pipeline,” says Tom Shropshire, a partner at law firm Linklaters. “But there is no doubt that the deals are still hard to do. The biggest players may now be able to attract financing on decent terms. For everyone else, it remains tough.”

He adds: “We are seeing a lot more interest in Initial Public Offerings given that there may be fewer M&A exit options. We expect to see some IPOs in early 2010, but many will not achieve the level of interest required to get the deals away.”

The combined IAS19 position for FTSE-350 companies moved from a small surplus at the beginning of 2009 to a £115bn deficit by the end of the third quarter, according to analysis by Hymans Robertson, the pensions adviser. “Going into to 2010, FDs will once again have to contend with substantial pension fund deficits,” says Clive Fortes, head of corporate consulting at Hymans. “Many companies will be faced with a new funding valuation by their trustees in 2010, which will mean that the market turmoil over the past few years will now start affecting cash contributions. We are seeing a number of companies setting up pension committees to tackle their pension fund issues head on.”

He adds that companies should consider the full range of options for managing their costs and risks. “For a typical FTSE-350 company, its pension scheme represents around a quarter of its market cap ­ that’s simply too big to ignore.”

Currency markets
The course that sterling, the euro and the dollar take could diverge next year, argues Matthew Harris, a foreign exchange specialist at Foremost Currency.

“Sterling is set to strengthen as recovery continues and alternative investment in London picks up again,” says Harris. “We saw great resistance when it dropped to £1.02 against the euro, so there may not be much further to fall from current levels if we see such resistance again,” he predicts.

“A lot of the eurozone economies are concerned about the euro being too strong and hurting their exports outside the zone. With the dollar, I can’t really see it moving too far in either direction. If anything, I would predict we will see the dollar develop short-term strength followed by weakness towards the end of the year, assuming global risk appetite continues to grow.”

Commercial property
“We envision there will be a two-speed market. As a consequence of the strength of sterling and influx of international investment, London and the South-East will see recovery first,” says Solly Benaim, head of real estate and construction at BDO.

“We would then expect the ripple effect with regions finally benefitting from high South-East prices and the perception that they are relatively cheap.”

That recovery could be upset by further setbacks in the financial sector and by the more insidious impact of a slow and prolonged recovery from recession,” says Martin Davis, head of UK research at property adviser DTZ.

“However, central London is influenced much more by world investment and trade activity than domestic UK factors.”

Taxation of foreign profits
“For those groups operating on the international stage and wishing to remain in the UK, their FDs will need to be familiar with the government’s reform package on the taxation of foreign profits introduced in the Finance Act 2009,” advises Simon Newsham from Newsham Tax Solicitors.

“While most of the reforms aim to ease tax compliance, the tax exemption for overseas dividends has come at a cost, with the introduction of a worldwide cap on the amount of interest deductions available in the UK. FDs will want to ensure maximum tax relief is available in the UK and this may lead to a number of debt restructurings.”