Jeremy Warner's Outlook: Governor maintains a hawkish stance even though Inflation Report points to lower rates

Beware the valuation at J Sainsbury; Triumph for BPB as French pay top dollar
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The Independent Online

Up, down or unchanged? We were no nearer knowing the answer on interest rates yesterday after publication of the Bank of England's Inflation Report. The Governor's subsequent press conference only added to the confusion. While the Inflation Report, if anything, pointed to softer rates, after slightly lowering its medium-term forecasts for growth and inflation compared with three months earlier, the Governor's own comments were more hawkish in nature. For him, the inflation risk is just as potent as the risk to growth.

The markets took the view that the Inflation Report made near-term rate cuts more likely and sterling fell accordingly. Yet I am not sure they are right about this. The Bank of England's Monetary Policy Committee would have known about these new, weaker forecasts when it met last week, and yet it didn't see fit to cut rates then. Why should it be any more inclined to act now the forecasts have been published?

Furthermore, though the forecasts show consumer price inflation falling below the Bank's 2 per cent target next year, it picks up again thereafter. Growth is meanwhile forecast to be a little bit weaker than in the August report, but the profile is broadly the same, with growth picking up to about 3 per cent annualised before slipping back a little as the impetus from public spending wanes and an anticipated revival in consumption again begins to ease.

This doesn't look to me like an unambiguous case for a rate cut. By assuming as much, the markets may be getting a little ahead of themselves, as they have done in the past. Ahead of the August Inflation Report, investors were convinced that there were at least another two interest rate cuts to come, taking them down to 4 per cent.

The Governor put the dampeners on that view when it emerged that he had voted against the rate cut imposed by the previous MPC meeting. The August Inflation Report pointed to the same conclusion by forecasting a sharp uptick in inflation in combination with a revival in growth. Many economists began to believe that the next movement in rates might even be up. Now they appear to be reversing their view again.

The confusion reflects conflicting viewpoints, both of which are equally valid; there is genuine lack of clarity. The data has rarely been more ambiguous, nor has the backdrop of inflationary and deflationary pressures been more difficult to read. Long gone are the days when national economies were essentially closed affairs influenced primarily by locally determined supply and demand. Today both inflation and growth are dictated as much by global factors as local ones.

The really remarkable thing about the inflationary spike just seen is that it is not hugely worse given the surge in oil prices. Time was when such a surge would have led to dramatic second round inflationary effects as manufacturers pushed up their prices to recover their higher costs and workers in turn attempted to compensate with higher wage demands.

Burgeoning Asian production in combination with high levels of low-cost immigrant labour (much of it from the new EU accession states) has neutered this traditional response to higher energy and commodity prices. A flood of cheap imports has depressed overall rates of inflation and prevented manufacturers from attempting to recover higher energy prices. Even in the service industries, where rates of inflation are higher, the influx of cheap labour from eastern Europe has prevented things from getting totally out of control.

So far, so uncontroversial. The unanswered question is for how much longer these influences can persist. We must surely be reaching the point where if another Pole hops on the coach to London there will be no one left in Warsaw at all.

As for cheap imports from China, this process too must surely be reaching the limits of sustainability. Chinese industrial expansion is in any case today aimed at meeting growing domestic demand. Any additional weakening of sterling will only further defuse the Chinese, deflationary effect, which rather points to the dilemma the Governor is so worried about - cut interest rates to feed growth and by weakening the currency it also feeds inflation.

There's room for genuine debate on these matters; the answers are still far from clear. The Governor is by inclination and position of the more cautious persuasion. He sees his role as protector of the Bank's credibility in controlling inflation and he's not about to gamble it on the idea that China will continue indefinitely to provide the powerful deflationary foil it has. Others take a more sanguine view. In the meantime, the Bank's de facto policy of leaving rates on hold and waiting to see what happens looks eminently sensible.

Beware the valuation at J Sainsbury

I've no problem with the contention that the J Sainsbury turnaround story under the banner of "Making Sainsbury Great Again" is already established and gaining momentum.

The prices are more competitive, the shelves are once more decently stocked, staff morale is back on the front foot, footfall is self-evidently much improved and there is a generally better feel about the stores all round. This has gained its reward in three consecutive quarters of improving like-for-like sales.

In the meantime, Justin King, the chief executive, has managed to get a grip on costs and bring the disaster of the company's new distribution system under control. The only obvious black spot is Sainsbury Bank, which has slipped into loss as a result of rising bad debt experience.

Where I've got the problem is with valuation, which seems to assume a recovery in profits of truly heroic proportions. The forward earnings multiple at about 30 times is nearly twice as high as Tesco, the market leader by a country mile with an established record of market busting sales and profits growth.

The main reason for the differential, of course, is the assumed potential upside in the profit margin, which at Sainsbury's is still less than half that of Tesco.

Yet Mr King himself admits there will be no margin recovery this year, and with no let up in pricing pressures, it is hard to see where it is going to come from thereafter. So far the King strategy has been to restore sales growth and price competitiveness whatever the cost. The next stage, which is restoring the margin, will be much less easy.

He's also saddled with the age old problem for Sainsbury that it still pays far too high a dividend, in part to satisfy the controlling family's demand for income. This supports the share price through a much higher dividend yield than is available elsewhere in the sector, but it also means that there is less money for price cuts and less money for investment. Mr King's task has only just begun.

Triumph for BPB as French pay top dollar

Congratulations to Sir Ian Gibson, chairman of BPB, and his chief executive Richard Cousins, who were last night close to agreeing a sensational deal on behalf of their shareholders by persuading Saint-Gobain of France to pay an astonishing 775p a share.

This is much less than the 832p a share they claimed the company was worth during this long, drawn out bid battle, but they can never have believed the shares would reach that price, and now it is the French who must take the risk that the bravado of the defence - double digit earnings growth into the indefinite future - was all along a load of baloney.

The case was a not entirely implausible one, based as everything is these days on burgeoning emerging markets demand, but it is also a triumph of hope over experience to believe that plasterboard has managed to throw off its cyclical past. If you buy the case, you can always reinvest the proceeds in BPB's new owner Saint-Gobain. On second thoughts, best take the money and run.

j.warner@independent.co.uk

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