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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.”

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