Down to the Wire

With the deadline of August 2nd fast approaching, a deal to increase the US debt ceiling appears a long way off, with Democrats and Republicans lawmakers still arguing over the size of speeds of spending cuts and tax increases.

Under congressional rules, the upper debt limit of $14.3tn will be breached by August 2nd, and without an increase, the US could potentially default on debt repayments. The repercussions of such a move would be catastrophic, leading to widespread panic across Equities and Bond markets and probably triggering a second global recession in four years.

Democrats are arguing for a larger increase in the debt ceiling, which will give more time for the economy to recover, whilst protecting social support programmes, and increase in taxation. Republicans are, by and large, also willing to allow the debt ceiling to increase but only by a small amount, which will only alleviate the problem for a few months. In exchange, Republicans would like to see a hefty reduction in public spending and fewer tax increases. A small number of hardline "Tea Party" members are taking the stance that they will not vote for any increase in the ceiling whatsoever.

Without the ability to increase their borrowing beyond 2nd August, the US would quickly be unable to meet interest and principal on its Treasury Bonds, which would trigger a default, quickly followed by the reduction or cessation of social security payments, which would cause widespread panic. The debt rating agencies, S&P and Moody's, are content to maintain the coveted "AAA" rating on US debt for the time being - however, should a deal not be reached, this will quickly be lost.

I take the stance that a deal WILL be reached, and that the current wrangling is little more than political point scoring. However, the deal will be something akin to a sticking plaster over a gaping wound, merely pushing the problem into next year when tough decisions will need to be made once again.

In the meantime, the safe haven that is Gold continues to march northward, pushing through $1625 an ounce on Wednesday.

A Greek Tragedy

Since 2010, the ongoing problem of Greece’s sovereign debt has cast a cloud over the Eurozone. Following the global financial crisis of 2008, Greece’s debt levels began to grow at an alarming rate (as seen in the chart opposite) which cumulated in Greece formally asking the EU/IMF for assistance in April 2010, via an instalment of €45bn and a repayment of €8.5bn in respect of Greek Government debt which was due for repayment. This caused Greece’s credit rating to be cut to “junk” status by Standard & Poors, citing increased fears that the Greek Government may default. This, of course, exacerbated the problem, as Greek Bond yields rose substantially.

In exchange for the bailout funds, the Greek authorities imposed austerity measures which, understandably, did not go down well with the Greek population. These includes large increases in direct taxation, and public sector pay cuts. Following a damning EU-IMF audit earlier this year, which showed that the austerity measures, where implemented, had done very little to improve the situation, S&P lowered the Greek credit rating further to “CCC”, which is the lowest of any global sovereign debt. The latest bailout request came after the dissolution of the Greek Parliament, and concerns that Greece would not be able to meet its’ obligations for payment due on 15^th July. A Bill bringing in additional austerity measures passed narrowly though the Greek Parliament on 29^th June, and as a result, the EU and IMF will forward the next instalment of a £98bn loan.

What is clear that this is simply a “stop gap” aimed at avoiding an immediate crisis. Until Greece can show real prospects of economic growth and also show that the austerity measures – including a freeze on public sector pay, rapid increase in the pension age, a rise in VAT, and most importantly a clampdown on tax evasion – are having a meaningful effect, all the EU have done is kick the can down the road until the next crisis point. At least a default – where Greece fails to repay its’ interest or capital on its’ sovereign debt – has been avoided for now, but many analysts view the EU monies propping up the Greek economy as a default in all but name.

Indeed, the fact that Greece has been given another shot of adrenaline has also switched investors’ attention to other EU states in poor financial health. This week, all eyes are on Italy, where 10 year Bond yields have surged to 5.4%, over concerns that a number of Italian banks would fail impending stress tests. In the past six months, both Ireland and Portugal have received bailouts, after suffering dramatic increases in their Government Bond yields, which leads to the interest payments on sovereign debt to become unsustainable.

This “contagion” to other EU states is unlikely to stop any time soon. And whilst it is possible to delay a default and buy time for countries such as Greece, Ireland and Portugal, Spain and Italy are a whole different proposition. A default – either actual or technical – of either of these two giants would almost certainly bring the whole Euro zone project into question. And don’t forget the USA has its’ own issues, as they have hit their technical debt ceiling of $14.3 trillion, and without the approval of Congress by 2^nd August, the US would face an economic catastrophe. I do not doubt that a fresh law will be passed in time to increase the limit before this date; however, the sheer scale of US Sovereign debt is truly frightening. Whilst Equities markets have been running along their own agenda over the past twelve months, it is only a matter of time before markets will be severely jolted by the reality of the debt crisis facing EU nations and the US. I continue to recommend to clients that they adopt a cautious approach and keep a limit on exposure to risk assets, including Equities.

A Crisis of Confidence, or something bigger?

You may have caught the recent news headlines that a number of leading retailers have either gone into administration or embarked in radical restructuring. Firstly, wine merchants Oddbins moved into administration in March, shortly followed by Focus DIY. During June, long standing furniture retailer Habitat, home improvement firm HomeForm (whose brands include Möben Kitchens,  Sharps Bedrooms and Dolphin Bathrooms) and fashion house Jane Norman and department store T J Hughes have all entered administration. More recently, chocolatier Thorntons and Carpetright have announced a radical plan of store closures. This week, Thomas Cook has warned of weak domestic demand for overseas holidays.

Each company has told of the same story – shoppers simply aren’t spending as much as they used to, and overheads (in terms of fixed costs) are increasing. In the case of HomeForm, Focus DIY and Carpetright, the weak housing market has led to a reduction in volume of sales.

A key measure of Consumer Confidence is published by Nationwide each month, and recent data has indicated that confidence amongst consumers remain low. Indeed, the survey for May 2011 showed confidence levels about the same as they were in the midst of the credit crunch in 2008.

As we have mentioned previously, consumers have been squeezed from all sides over the last three years. Unemployment has risen sharply together with a decrease in job security generally. For those in employment, wage inflation has been minimal. Against this backdrop of static incomes, large increases in the costs of petrol and diesel, gas and electricity bills, higher food prices, more expensive clothing and hikes in car insurance and public transport have all combined to reduce the discretionary spending power of consumers. Undoubtedly, the VAT increase from 17.5% to 20% on January 4^th has not helped either. Even the reduction of base rates to 300 year lows, which has led to cheaper mortgages for many on variable or tracker rates, has done little to help ailing retail sales and consumer confidence.

A further consideration is the consumer’s ability – and willingness – to borrow to fund major purchases.  Much of the spending on big ticket items over the last ten years has been driven by borrowing, particularly through Mortgage Equity Withdrawal (MEW), where homeowners used their house like a “cash machine”. This was fine all the time house prices were rising, however with prices gently falling recently, this is no longer an option for many, together with the stricter lending criteria from banks and other lenders, whose fingers are still smouldering following the much talked about credit crunch of three years ago.

One could argue that once the economic outlook improves (which is the most likely scenario in the next two to three years although growth is likely to remain subdued) consumer confidence will rise along with shoppers’ spending power. However, I wonder whether a bigger change is occurring in the nation’s psyche?  Following the binge during the “Noughties”, shoppers have become far more price-conscious, and this has been witnessed by the rise of discount retailers such as Primark, Matalan, Aldi and Lidl. This is a trend I see continuing. Similarly, top end retailers, such as John Lewis, continue to post impressive results, as the mass affluent are least affected by the weak economic conditions. But for those retailers caught in the overcrowded middle, the prospects are not great.

The announcements of T J Hughes, HomeForm, Jane Norman and Habitat come at the end of a quarter, when rental payments typically become due. One has to wonder how many other retailers will come find themselves in the same situation at the end of September?