March 2008 Newsetter...click here for full PDF version

A rebalancing act
As the new head of Northern Rock during its period of "temporary" public ownership, industry veteran Ron Sandler has said little yet on his plans for the company, except that he will be returning the bank to a more "sustainable" size. His first mission will therefore undoubtedly be to rebalance the savings/loan equation. To date, Northern Rock has offered some very competitive savings rates designed to help retain existing savers as well as attract new ones. However, under the terms of the nationalisation agreement, Northern Rock will not be able to aggressively seek new customers. Because of the gilt-edged guarantee to its savings and loan book which Government ownership brings, it is deemed to hold an unfair advantage over other banks and building societies. Therefore, in the longterm, building up the number of savers as a way to rebalance the books won’t be an option. This means Sandler will have to address the other side of the equation – ie: reduce the amount of mortgage debt. Even before nationalisation, the bank had already priced itself out of certain areas of this market, reducing its new business. For existing mortgage holders, there are no problems in the short-term, but they will have a decision to make at the end of their fixed rate or discount term as there is unlikely to be such a competitive roll-over product waiting for them. Savers and mortgage holders alike might just have to look elsewhere.

Are ISAs tax free?
ISAs are tax efficient, but the exact benefits can vary. You pay no additional tax on the income from your ISA savings and investments, and no tax on any capital gains. You don’t even have to tell the Inland Revenue you have one, let alone what income and capital gains are generated. But, while cash ISAs are free of tax, and corporate bonds allow you to reclaim the 20% tax on the interest payment they make, equity-based ISAs suffer a withholding tax which cannot be reclaimed. Effectively, you currently pay 10% tax on dividend income - whatever your actual rate of income. However, there is still a significant advantage for higher rate tax payers.

Another chapter for Northern Rock
“The medium term outlook for the Company is very positive". In hindsight, Chief Executive Adam Applegarth’s assessment of the future prospects for Northern Rock when he announced half-year results in July now looks naïve at best. Wind the clock forward just seven months, Applegath and most of his senior management colleagues have departed and Northern Rock is now in Government hands. In taking the decision to nationalise, Chancellor Darling said that the two private bids on the table at the official deadline of 4th February did not offer value for the taxpayer (an initial bid, from Lloyds TSB shortly after the crisis began, had already been swiftly rebuffed). The taxpayer became involved in the fortunes of Northern Rock when the Government promised to guarantee customer deposits to prevent a run on the bank. In effect, Northern Rock now owes us all around £25bn and the Government needs to ensure we get that back. The two rejected bids were from Northern Rock’s management team and a consortium headed by Sir Richard Branson’s Virgin Group. A third bidder Olivant, a private equity group, pulled out just before the final deadline blaming the Government’s inflexible terms. This was considered a major setback because the Olivant bid had the backing of Northern Rock’s largest shareholders – hedge funds RAB Capital and SRM Global, who between them owned almost a quarter of the shares. These hedge funds then switched their allegiance to the management team buyout. They didn’t like the Branson deal because of his proposal for a £1.25bn injection would have diluted the value of existing shareholdings. Of course, they like nationalisation even less because potentially, it leaves them with nothing. They are currently threatening to sue, but are on shaky ground. The legal battle is likely to come down to what the shares would have been worth without the Government’s guarantee, which is almost certainly nothing. Neither side can take the blame for the failure to agree terms. The Government is thought to have demanded a hefty price for its guarantee, which the bidders were unwilling to pay. As to why the decision took so long, the Government argues it was an important decision and needed to be weighed carefully. The opposition accuse the Government of indecisiveness and incompetence. The real answer therefore probably lies somewhere in between.

UK market update
The UK market looked like it might end the month with a brief rally, but the FTSE All Share slipped back on the last day of trading (Source: Financial Express Analytics). The view seemed to be that if things weren’t exactly getting better, then at least they weren’t getting any worse. All eyes were on the banking sector with many of the big names reporting full year results at the end of the month. In general, the news was good - there were further write-offs, but nothing to spook the market significantly. Northern Rock’s nationalisation provoked plenty of comment, but there was little reaction in the market.Management in the financial sector sent out a confident signal with some aggressive dividend hikes. Barclays raised its dividend, HBOS didn’t let disappointing results hold it back and Royal Bank of Scotland was content with a relatively conservative rise. There were murmurings about the sustainability of the dividend hikes, given the ongoing problems in credit markets, but dividend cover looks reasonable at current earnings levels. But the news wasn’t universally good. Rentokil issued a profits warning, while Redrow saw a 35% fall for the full year. The macro picture, on the other hand, was relatively quiet and continued to give out mixed signals. The Bank of England kept rates on hold at 5.25% as expected. Inflation was marginally higher at 2.2%, from 2.1%, but the housing market remained gloomy. UK unemployment continued to fall and retail sales were unexpectedly up in January after a weak December.

US market update
After last month’s flurry of interest rate cuts, February proved to be a boring month for the US in comparison. Federal Reserve Chairman Ben Bernanke delivered a gloomy prognosis for the US economy, saying that the outlook was deteriorating and a weaker labour market could undermine consumer spending. He suggested towards the end of the month that the US may seesome smaller regional banks fail. In a month where there was very little good news for US economists, consumer spending was the only area that held up. US retail sales rose in January after a weak December. However, this was not enough to improve sentiment as soaring oil prices and higher consumer prices stoked inflation and investors panicked about the Fed’s capacity to cut rates. Fourth quarter GDP slipped to 0.6%, down from 4.9% in the third quarter. Net exports remained surprisingly strong and without these, the economy would have contracted. Unemployment rose, but personal consumption expenditure continued to climb in the fourth quarter and remained high on the year. Bernanke's reassurance that he would continue to cut rates despite these inflationary pressures fell on deaf ears. All these problems had a significant effect on the dollar, which fell to new lows against the Euro and a three year low against the yen.

Cash ISAs
In addition to building society and bank accounts, cash ISAs can be invested in certain National Savings & Investments accounts, as well as in unit trusts or openended investment companies (OEICs) that invest in cash/money market funds. At the more exotic end of the market, there are also some structured products that qualify for cash ISA investment, and offer a form of capital protection. However, while these are marketed with the potential of sizeable gains, some use complex market instruments that are not as easy to understand as a bank account, and it may be worth considering whether you are willing to accept
additional risk before investing.

The devil and the deep blue sea
The Bank of England has cut UK interest rates twice in the last four months. However, faced with a paradoxical scenario of rising inflation and slowing economic growth, where does the bank’s Monetary Policy Committee (MPC) go from here? Should we expect anything more? UK interest rates are now 5.25% following the MPC’s latest move in February. Both cuts were implemented to help stave off an economic slowdown and many commentators believe that further cuts remain necessary. However, with inflation continuing to run above the government-imposed target of 2%, the MPC’s scope for further cuts appears to be limited. On the other hand, with economic growth on the slide, failure to cut further could help to tip the UK into recession. The Bank of England sees UK economic growth falling over 2008, but also expects inflation to remain a headache. February's minutes indicate that their projection was for higher energy, food and import prices to push inflation up sharply in the near term before it falls back towards the target rate of 2%. This indicates a tricky balancing act for the MPC, which is supposed to control inflation, but which must also ensure that the economy does not stall. However, interestingly, at that meeting, there was one lone dissenting voice in the vote for a 0.25% cut. Professor David Blanchflower actually voted for a more drastic cut in rates - of 0.5% - citing the “risk of a very sharp slowdown in UK growth”*. Higher inflation figures, though, are making it harder for the MPC to cut interest rates and their priority now appears to be bringing inflation back into line. The Committee has shown that it is mindful of the risks of economic slowdown with these two interest-rate cuts but the effects of these cuts will take time to feed through to the bottom line. Rates were consequently left unchanged in March. All things considered, we might see another cut in UK rates over the next couple of months, but we might have to wait until the latter part of theyear for anything further. Certainly, the MPC is not interested in emulating the dramatic monetary easing of the US; instead, it appears to be aiming to deliver a policy of rational and considered moves. Only time will tell whether its policy will be successful; in the meantime, the UK will probably need to tighten its belt.

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