Jeremy Warner's Outlook: Bank acts on debt-fuelled consumption

Attractions of undervalued oil majors; Now Dubai targets struggling Airbus
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The Independent Online

Yesterday's quarter-point interest rate rise was met with the usual barrage of complaints from industry, retailers, estate agents and mortgage holders. The Bank of England is over-reacting, they whined. More time should have been allowed to see what effect previous rate rises were having before acting again. To a man, they warned of difficult times ahead.

The headline in London's Evening Standard - "Mortgage misery as rate rises to 5.75 per cent - highest for six years" - said it all. Another dollop of pain all round, then. But hold on a moment.

Rising rates are only painful if you happen to be among the ranks of Britain's debtors. This is admittedly a strongly growing cohort, but, all the same, there are still approximately six times more net savers in Britain than net borrowers. For this majority, rising interest rates are a boon, even if banks remain their customary tardy selves in handing the benefit on. The practice of "gapping" - raising lending rates immediately but savings rates only later and even then only by a fraction of what the rise in rates would warrant - is still depressingly prevalent.

Despite five rate rises in less than a year, it remains tough to find deposit rates that, after the payment of tax, protect savings from the present level of inflation. It is this phenomenon that has helped fuel the growth in debt and now provides one of the chief justifications for rising interest rates.

The harsh reality is that monetary conditions have been too loose for too long, which has led to now quite clear signs of overheating in the economy. With growth in the first quarter still chugging along at an annualised rate of 3 per cent, and the savings ratio recently reported to be at its lowest level since 1960, is it altogether surprising that the MPC should be raising interest rates? If anything, the MPC ought to be criticised for leaving it too late.

Yet there was the familiar chorus of boos yesterday from those who would rather have the party continue. Would that it were possible. The bottom line is that failure to act now would almost certainly require much harsher treatment later on.

The number of savers may outnumber the debtors, yet with the half million-pound mortgage now relatively commonplace, the total size of the debt these days dwarfs the savings. The upshot is that, for many, the present tightening will indeed feel painful. For the millions forced to remortgage out of the low fixed-rate deals available three years back, a quite severe squeeze in disposable incomes is in prospect. Housing may even become a buyers' market again, with prices already falling in some parts of the country.

How might the economy respond? So far, the present tightening cycle has had pretty much zero effect on both consumer spending and house prices. With squeezed disposable incomes, households have chosen to borrow more and save less rather than curtail spending habits. This may now change, especially if continued strength in the world economy prompts the MPC to raise rates even further to 6 per cent or higher.

The immediate impact might paradoxically be inflationary, as employees seek to recover disposable income through higher wage claims. Yet as consumption slows, the at-present exceptionally tight jobs market will become looser and inflationary wage demands less easy to sustain. The return of real interest rates might, moreover, encourage higher savings, compounding the effect on consumption of higher debt servicing costs. For high-street retailers, things could become ugly.

And the cause of all this "misery"? Blame it all on the Chinese, whose rapid development was at first a powerfully deflationary influence on prices but is now becoming decidedly inflationary, as high economic growth, wherever it occurs, always is in the end.

Attractions of undervalued oil majors

My note the other day arguing that there is life in the oil majors yet has caused a stir among readers. As you might expect from an environmentally-conscious readership such as The Independent's, many have argued that the low-carbon economy the world must adopt to deal with climate change means oil companies have little or no future.

At the other end of the spectrum comes the possibly more realistic if depressing view that Asian growth means that demand for hydrocarbons will continue to grow exponentially, making these companies extraordinarily valuable properties.

A recent circular from Morgan Stanley on Royal Dutch Shell lends some support to this argument. According to Morgan Stanley, the markets are profoundly mispricing the oil majors. The investment bank refers to "a massive gap" between Shell's market value and the underlying value of the company which it calculates at perhaps as much as $120bn. The same argument could be made about BP, Total, and perhaps Exxon Mobil too.

How come? Morgan Stanley makes the case on a simple sum-of-the-parts argument. The focus on Shell's declining upstream activities disguises a massive and highly valuable downstream business, including some of Europe's biggest refining, marketing, gas and power and chemical businesses.

Yet the argument can as easily be made about the oil majors' reserves of oil and gas, which, given the high oil price, seem to be hugely undervalued by present share prices. There is a big difference between the present price of oil and the value that markets attribute to some of its major producers. The chief reason for this mismatch is that markets are sceptical that the oil price can be sustained at these historically high levels. The general assumption is that, come the next downturn, it will slump back down again.

The really interesting thing is, however, that it needs to fall back an awfully long way to make current valuations look expensive. The great bulk of these reserves are in at assumed development and production costs of $25 a barrel or less.

If oil remains scarce and in demand, reserves at such prices look massively undervalued, so much so that you have to wonder whether the likes of BP and Shell might eventually become targets for the Chinese in what is already an extraordinarily aggressive search for assets with which to secure the country's future energy needs. If it were thought politically acceptable, they would no doubt already have tried.

Were it not for their size, these companies would also be an absolute no-brainer for private equity. As I have argued, a BP/Shell merger continues to look implausible. The regulators would never allow it. But a bid by others for one or both these companies shouldn't altogether be discounted. Likewise, they might soon find themselves the target of activist investors, determined to obtain a more aggressive extraction of value.

Now Dubai targets struggling Airbus

As highlighted above, in suggesting that BP and Shell might become targets for China, strategic and geopolitical objectives are playing a growing role in investment. A case in point seems to be Dubai International Capital's acquisition of a 3.12 per cent stake in EADS, the company that owns Airbus.

Airbus was always more of a political endeavour than a commercial one, so it should perhaps be no surprise to see others attempting to muscle in on the action. Already Russia's VTB bank has bought a 5 per cent stake with the apparent intention of securing boardroom representation and assembly work for Russia.

The Dubai stake may likewise have something to do with Dubai's stated ambitions of becoming a major player in aerospace. Whether either of them can ever exert any influence over this warring Franco-German partnership is open to question.

Peter Hintze, the German government's aerospace coordinator, was quick to warn his new shareholders against holding any such aspirations. "EADS will remain a European company with a special German-French responsibility", he said. If he had said, thanks, now sod off, he could hardly have put it more bluntly.

j.warner@independent.co.uk

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