A case for gilt-edged
Nicholas Davenport
After the unrealistic propositions of the Labour party conference it was comforting to listen to the down-to-earth talk of commonsensible and fair-minded Ted Heath. The stock markets were responding well until they were halted by the upsetting news from the Middle East and Washington. I am ashamed to say that it was the latter which upset them most. The turn-up in Wall Street had been a major factor in our market recovery: a turn-down would be most discouraging. If only the American public .could acquire some of the confidence of the Israelis and back their own government to do the right thing! Reading the Green Paper on Phase Three and listening to Ted Heath — there was really no one else worth listening to — I wondered whether it was right to be a bull of the equity market or the gilt-edged market or neither. I came to the conclusion that if it was right to be a bull of anything my choice would go to gilt-edged.
The Green Paper is buying industrial peace (we hope) by being more lenient over wages than it is over prices and profits. Mr Heath's words were significant: "First and foremost is the need to keep down Prices" followed by "much greater freedom for negotiation on pay." Certainly it was right to introduce more flexibility over pay negotiations. The choice between £2.25
per head, which would help the lower paid, or seven per cent per head with a limit of £350 a year per individual, will make it much easier to reach pay agreements. And Mr Heath added the ' threshold ' protection, that is, an extra pay increase of up to 40p a week payable if the retail price index reaches seven per cent above its level at the beginning of Phase Three (November 5) with another 40p per week for each percentage point the index may rise thereafter until the end of Phase Three (twelve months on). This very generous ' threshold ' protection should make it possible for most unions to reach satisfactory pay settlements as readily as they did under Phase Two. Allowing for overtime and wage drift average earnings will probably rise in the first quarter of 1974 to 17 per cent above 1973. Militants will find it very hard to bring, their men out on strike under these conditions. And most union leaders do not want to have unpleasant strike confrontations with the Government before the election in case their strong-arm tactics give an overwhelming victory to Mr Heath.
While an uneasy industrial peace may therefore be secured — though industrial disputes may' still be expected to upset production runs here and there — the code 3 is harder on profits. It
limits more strictly the extent to which cost increases can be passed on as price increases. The scope for reducing costs to offset this through higher Utilisation of existing plant will also be more limited. The Government has allowed any reduction in profit margins through the price controls to be limited to 10 per cent but the CBI regards this as inadequate protection. It must therefore be expected that company profits will fall over the coming months. Of course, this fall may be offset by greater foreign earnings or by larger profits on exports but this will depend on the circumstances of each company. And we must not forget that the growth of the economy will be slowing down next year from over 51 per cent per annum to 31 per cent.
I cannot therefore see any bull point for equities on the profit ground. Dividend increases are still to be restricted to five per cent and the CBI feel that this will make it extremely difficult for industry to attract new investment. And in that event company profitability will fall.
But, you may ask, where is the market if Mr Heath is going to be lenient over pay settlements? Surely that is going to make the inflation worse, coming on top of the inflation we have to import from soaring world commodity prices. The answer to that is twofold: first, the Price Commission is going to be more strict in holding the rise in retail prices (which has already decelerated); secondly, the Government hopes that the slow down in world commodity pricks (the index was almost unchanged in September) will continue. The war in the Middle East may temporarily dash these hopes but clearly it is not likely to be a long war. The rise in the prices of basic materials and fuels used in manufacturing inchistry has been 38 per cent compared with a year ago — and I have never known such a steep rise in world commodity prices to be sustained for long.
The adverse trend in the terms of trade, which has sharply worsened the deficit in our balance of payments, may also be slowing down. The export unit value is now rising more quickly. The current trade deficit in September — £113 million — was lower than the market had been expecting. Of course, the deficit for the year will be over £1,000 million but if there is any truth in what Mr Peter
Walker says in his bullish. propaganda from the DTI there could be an expansion of £3,000 million in our exports this year.
World trade in manufactured goods,. he said, is expected to rise by 13 per cent in volume this year and by more than 10 per cent next year and if we keep our share of it (Which is a big 'if') we shall eliminate our trading deficit in 1974:
Apart from these perhaps controversial points there are two factors solidly in favour of the gilt-edged market. First, there has been a drop in interest rates in America, the Treasury bill rate having fallen from 8.9 per cent to 7.6 per cent. Secondly, there has been a sizeable cut in the £4,000 million borrowing requirement, the standing bugbear of the giltedged market. The Times Perhaps exawrated the cut by suggesting that it had fallen to E2,500 million but I would certainly say that it had dropped to £3,000 million.
The Treasury financing of the deficit has been mitigated to the extent of some £500 million by the flight from sterling (which cancels Treasury bills previously issued) and to the extent of some £500 million by the delays in governinent spending on capital account through the over-heating of the economy. One must also allow for 'fiscal drag,' which means that inflation boosts the revenues from both direct and indirect taxation and so reduces the overall deficit. Of the £3,000 million or less left the Bank has so far been able to sell £1,000 million of stock to the banks and the public and if the radical but excellent proposal of my colleague, Giles Overreach Skinflint, were adopted the balance could easily be met by directing the insurance companies and the pension funds to buy more government bonds and less equity shares. Such direction has been tried before — by a Tory government which once made these investment institutions put up some £200 million for the Export Credits scheme.
Some conservative readers may regard my preference for giltedged at the moment as somewhat speculative. I admit there is an element of gamble in Mr Heath's policy. It is a gamble on whether high wage awards will buy industrial peace. It is a gamble on whether raw material prices will fall. It is a gamble on whether there. will be.no run on the £. It is a gamble on the economy not becoming dangerously over-loaded. But life is a gamble and all business, as Keynes used to say to me, is a bet. 1 think Mr Heath's gamble is thoroughly justified. And why should stockbrokers complain? A gamble makes for a more active market.
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