Two facts to turn you into an optimist

The gloomsters are wrong: the worst of the recession is probably over

Simon Wolfson

Moderation in print is harder than it looks. So an article suggesting that things are not as bad as the gloomsters would have us believe, without saying the recession is over, is a real challenge. But that is my view. The recession will still take a while to end but the worst is probably over. At the beginning of this year Next plc forecast that its like-for-like sales would be down for the rest of the year - and we still believe that will be the case. However we also pointed out that the financial pressures on many of those still in jobs would be reduced because of lower mortgage payments and fuel and energy costs.

While many will wisely chose to save that money rather than spend it, eventually consumer confidence will return and the economy will come out of recession. There are signs that this is underway. Two vital pieces of information are important indicators of the state of the economy. The first relates to employment, the second to the complex world of mortgage-backed securities.

Unemployment is indeed rising but crucially employment is not falling nearly as fast. Since its peak in May employment has fallen by 162,000; in that same period unemployment has risen by 401,000. So while more people are claiming benefits - and this is a headache for Government - the larger labour market means that the impact on national earnings will not be as extreme as expected.



In effect new entrants to the labour market will replace some of the spending lost from the unemployed. This will be of little comfort to those who lose their jobs; but it will be important to the general health of our economy and soften the blow of rising joblessness.

Alongside more encouraging employment statistics it appears that the problem of bad debts is not quite the catastrophe the markets were expecting. A key indicator of this is that defaults on mortgages are nothing like as high as the depressed prices of mortgage-backed securities would suggest.

Mortgage-backed securities are large pools of mortgages lumped together by banks and sold on to investors so that the banks can raise funds. In a given pool the best 93 per cent might be classed as triple AAA. Investors who buy these securities will only lose their money if more than 7 per cent of the total loan is not paid back. A 7 per cent loss would require many more than 7 per cent of borrowers to default, because the value of repossessed properties is likely to cover a significant portion of any unpaid loan.

Let's say the mortgage loans represent a not untypical 70 per cent of the value of the underlying property, even if the properties fall in value by half the bank will recover 71 per cent of the value of its loan. So, in this example, for the AAA bonds to incur any losses an astonishing 23 per cent would have to default - that's more than one in five. That is simply not happening; repossession rates are still well below 1 per cent.

Unlike the recession of the early 1990s interest rates have fallen, making defaults even less likely. Yet AAA mortgage-backed securities are trading at 93p in the pound: this price implies a default rate of more than 40 per cent.

The conclusion must be that mortgage-backed securities are now trading at way below reasonable value. In time, the smart money will take advantage of this and banks will see the market value of their assets increase. This will free up the banks to lend more money and, slowly but surely, the banking sector will come back to life.

The markets have in fact overly punished the banks for careless lending. The astonishing bounce in Barclays' shares (up by more than 200 per cent in a couple of months) is testament both to the remarkably strong and sensible leadership of that company and to the slow awakening of the markets to a world that is not quite as dangerous as the pundits have indicated.

So we can expect a slow but steady return to normality, an economy bruised but still breathing. Don't expect an overnight cure, we still have a difficult year ahead, but hopefully the foundations of a recovery are in place.

The biggest risk now lies in public finances and here the outlook is not at all good. With revenue falling and expenditure set to rise to nearly 45 per cent of GDP our national debt will increase to more than a trillion pounds. This could undermine any recovery and burden the country with years of stagnation as we try to pay off the debt. The risk is that increased taxation will sap the economy's lifeblood. Furthermore the state of government finances may continue to weaken the pound, stoking inflation as imports become more expensive.

There are three key messages for the Chancellor in the run up to the Budget. First, the measures taken to stabilise the banking sector are slowly beginning to bear fruit - things are not as bad as some had foretold. Second, don't splurge money on a wasteful stimulus package. The £15billion VAT giveaway was helpful in containing prices but did nothing to boost spending. Any stimulus package is unlikely to have any effect other than to strain an already over-stretched balance sheet.

Third, the Government must start to curtail its spending. According to its own forecasts, it will increase its spending by nearly £100bn over the next three years. Ministers must not tell us that reducing public spending will only harm essential services; they have to work smarter to be more efficient. Businesses have been working hard to pare their costs without letting down their customers. The Chancellor has no excuse not to do the same thing.

Simon Wolfson is the chief executive of the retailer Next PLC

From : http://www.timesonline.co.uk