In economic terms, what has changed since our last update is that confidence has improved markedly. Specifically:
■ Economic output may already have stopped falling. The National Institute of Economic and Social Research caused quite a stir when it postulated in June that the UK may technically be out of recession. More recent data has since cast doubt on that thesis, but many other bodies believe we are past the worst.
■ Having spent most of the first quarter shifting recovery expectations backwards into 2010, economists and forecasters spent much of the second quarter moving them forwards again.
■ Some leading indicators have turned more positive. The Baltic Dry Index, which measures shipping activity – a proxy for economic activity – has risen almost sixfold since earlier this year, although from a very low base.
■ Inflation has started to come down -– consumer price inflation is now below the Bank of England's target – and is expected to continue doing so although 'core' inflation (excluding fuel and food) remains stubbornly high.
■ Retail sales have remained relatively buoyant, with car sales boosted by the scrappage scheme. However, it's worth noting that in the US, whose housing downturn started earlier than ours, retail sales remained strong initially, but are now falling.
■ The Bank of England has paused its quantitative easing (QE) programme, to the surprise of many observers. Opinion is divided as to whether the bank has done enough, and whether QE has worked.
■ Unemployment has continued to rise and is forecast to go on doing so. This is not so much due to the shedding of existing jobs, although there's plenty of that going on, but the lack of new job creation. Unemployment is not just a problem in the UK; it is much higher in many eurozone countries, notably Ireland, Spain and Germany. This matters, because these countries are our key trading partners.
Scenarios
It may not be apparent for some months whether the economic pick-up seen over the past few months is the start of a real, demand-led recovery, whether it's just down to a one-off rebuilding of inventories, or even just a reduction in the rate of destocking.
However, it's certainly possible that economic recovery will come quicker than many expected. This is the bullish case: having entered the downturn with healthy balance sheets and moved quickly to reduce inventories, companies will be better able to maintain their margins. A more flexible approach with employees – unpaid leave, extended holiday, pay freezes and so on – will limit the growth in dole queues. And the impact of unemployment will in any case be mitigated by the fact that for many more people, low interest rates, low inflation and lower commodity prices mean extra spending power. Government tax revenues will pick up more quickly than expected. US house prices will stabilise and start to recover, progressively restoring normal activity in the capital markets.
The doomsday scenario is deflation and depression, less talked about these days, but still a possibility given the amount of unused capacity in the world's major economies and some of the more alarming predictions for employment and wages. Or, there is the idea that the day of reckoning has merely been postponed. Developed nations may try to reflate their way out of debt. Sooner or later, they would have to ratchet up interest rates to bring the inflation they have created back under control, pushing already fragile economies back into a nasty downturn. This happened in the late 1970s and early 1980s, in both the UK and the US.
The most likely outcome, we think, is that we are in for a period of relative stagnation. The economy will no longer be shrinking rapidly, but nor will it be recovering strongly. State-sector spending will have to fall and taxes will rise, holding down growth in consumer spending. And crucially, bank lending will remain cautious, which will limit new corporate investment and therefore job creation. Companies will no longer be collapsing around our ears, but nor will they be firing on all cylinders.
If this prognosis of restrained economic activity – a recovery that doesn't feel like recovery – comes to pass, what would that mean for key asset classes? Below, we highlight what has happened since our last update at the start of April, and how things might work out for the remainder of the year.
