The Green Budget

The Green Budget

The Economic Outlook

January 2005

Professor David Miles +44 20 7425 1820 [email protected]

Morgan Stanley does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

Please refer to important disclosures at the end of this presentation

The UK economy has been unusually stable in recent years. But there is no strong evidence that there has been an increase in the sustainable long-term growth rate of the economy.

The Treasury believes that the sustainable ‘trend’ growth rate of the economy is 2.75% a year, falling to 2.5% in 2007. This looks plausible.

But our analysis suggests that there is little or no spare capacity in the economy – this is important for estimating when the cycle ends and for near term growth prospects .

We think growth will be somewhat weaker than the Treasury forecast in the short term, but its longer-term projections look plausible.

But there is the risk of a more dramatic slowdown if the household sector decides to sharply increase its saving rate from the current low level.



Economic growth less variable than in the past

Source: ONS

-5

-3

-1

1

3

5

7

9

11

1957 1966 1975 1984 1993 2002

%

UK GDP (volume, Y%)


Inflation has been low and stable since the mid 1990’s

Source: ONS

0

5

10

15

20

25

30

1957 1966 1975 1984 1993 2002

RPI - inflation CPI - inflation

%


Annual growth and inflation by decade

1957-1964

1965-1974

1975-1984

1985-1994

1995-2004

Growth in real GDP 3.3 2.7 1.5 2.6 2.8

Growth in real GDP per capita b 2.6 2.3 1.5 2.3 2.4

Variability of real GDP growth (standard deviation of annual change)a

2.6 2.3 2.4 2.2 0.7

Variability of retail price inflation (standard deviation of annual change)a

1.6 3.8 6.3 2.5 0.8

a Standard deviation of the year-on-year percentage change using quarterly data. b Real GDP per resident population; 2004 is a Morgan Stanley estimate. Other indicators are year-to-date. Sources: ONS, Morgan Stanley research


UK per capita output catches up with its European peers

% of US 1980 1990 2000 2003

UK66 67 72 74

France77 75 73 72

Germany a

80 78 72 70

Italy74 74 71 71

US100 100 100 100

a West Germany through 1990. Source: OECD, Constant 1995 prices and PPP, Morgan Stanley Research Estimates


Where we are in the business cycle and what future cycles and trend growth look like is crucial in assessing the fiscal outlook.

We look at a range of evidence on the issues.

Simple statistical techniques suggest no spare capacity.

Looking at the capital stock and conditions in the labour market gives a similar picture.

The evidence for a sustainable improvement in the rate of growth of the economy over the medium term looks thin.

Cycles, Capacity and Trend Rate of Growth


Hodrick-Prescott measures of spare capacity

Source: ONS and Morgan Stanley Research

-9%

-7%

-5%

-3%

-1%

1%

3%

5%

7%

9%

1980Q2 1984Q2 1988Q2 1992Q2 1996Q2 2000Q2 2004Q2

1600 HP 100 HMT


-9%

-7%

-5%

-3%

-1%

1%

3%

5%

7%

9%

1980Q2 1984Q2 1988Q2 1992Q2 1996Q2 2000Q2 2004Q2

1600 CF HMT


Hodrick-Prescott and Christiano-Fitzgerald (CF) measures of spare capacity


Alternative estimates of spare capacity

Method Q1 2004 (% GDP) Q2 2004 (% GDP)

Q3 2004 (% GDP)

HP filter (λ= 1600) 0.0 0.3 0.1 HP filter (λ= 3600) -0.2 0.1 -0.1 HP filter (λ= 100) 0.2 0.4 0.1 CF filter 0.8 1.0 1.0 Linear trend 1.2 1.5 1.3 HM Treasurya -1.0 -1.0 -1.0

Source: HM Treasury, Statistics Office. Morgan Stanley Research. Note: The linear trend is estimated via Ordinary Least Squares (OLS). Note: negative numbers imply spare capacity; positive numbers imply output is above trenda % of potential output


Employment and unemployment headcounts (million)

Source: ONS, DataStreamNotes: UK LFS employment, unemployment levels in million, headcount.

1.0

1.5

2.0

2.5

3.0

3.5

1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

23

24

25

26

27

28

29

Unemployment (LHS) Employment (RHS)


Employment and participation rates (%)

Note: Percentage of working age population. Sources: HM Treasury and ONS. Source: Labour Force Survey, ONS, DataStream. Participation rate: percentage of working-age population who are economically active.

77.0

77.5

78.0

78.5

79.0

79.5

80.0

80.5

81.0

81.5

82.0

1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

68

69

70

71

72

73

74

75

76Participation (LHS) Employment (RHS)

% %


Ratio of output to the stock of capital

Source: ONS. Morgan Stanley Research Note: net of residential housing

0.40

0.44

0.48

0.52

0.56

0.60

1987 1989 1991 1993 1995 1997 1999 2001 2003

Fitted trend Actual


Net national saving rate as % GDP

Sources: ONS and DataStream

0

1

2

3

4

5

6

7

8

1987 1989 1991 1993 1995 1997 1999 2001 2003

National net saving rate

%


Treasury and Morgan Stanley trend growth estimates

HM Treasury

MS Benchmark case

(HP lambda=1600) CF Band pass Filter

1986H1 - 97H1 2.55 2.44 2.50

1997H2 - 01Q3 3.06 2.98 3.02

2001Q4 - 06Q4 2.75 2.55 1.90 -2.10

2007Q1 - 09Q4 2.50 2.55 2.45



Treasury forecasts for key economic variables

Year-on-year growth (%)

2003(outturn)

2004 2005 2006 2007

Real GDP 2.25 3.25 3.00-3.50 2.50-3.00 2.25-2.75

Domestic demand 2.5 4.00 3.00-3.50 2.50-3.00 2.25-2.75

Household consumption 2.25 3.25 2.25-2.75 2.00-2.50 2.00-2.50

General government consumption

3.50 4.50 3.00 3.00 2.50

Fixed investment 2.25 6.50 6.75-7.25 3.25-3.75 2.75-3.25

Exports 0.0 2.25 6.50-7.00 6.25-6.75 6.25-6.75

Imports 1.25 4.75 6.00-6.25 5.25-5.75 5.25-5.75

CPI (Q4) 1.50 1.25 1.75 2.00 2.00

Nominal GDP 5.25 5.50 5.75-6.00 5.25-5.75 5.00-5.50

Sources: HM Treasury 2004 Pre-Budget Report (December 2004)


The near term forecast of HMT depends upon fairly strong growth in exports and no very significant slowdown in consumer spending growth.

There are obvious risks to that forecast – and in terms of overall demand the risks are probably more on the down side.

Conditions in the housing market and a starting point with very low household saving suggest slower consumer growth is likely.

Morgan Stanley expects slower growth in the global economy and with sterling probably overvalued a sharp rise in exports this year looks unlikely.



Income to house price ratios relatively high

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1969 1973 1977 1981 1985 1989 1993 1997 2001

ODPM - House Price to Income Ratio (based on lenders data)

Source: Office of the Deputy Prime Minister


Mortgage payments still relatively affordable

Source: Bank of England, ONS and Morgan Stanley Research Note: interest payments plus mortgage principal payments as % post tax household income.

7

8

9

10

11

12

13

14

15

16

1988 1990 1992 1994 1996 1998 2000 2002 2004

Debt servicing as % post-tax income

%


House prices and the saving ratio

Source: Bank of England, ONS and Morgan Stanley Research

0

2

4

6

8

10

12

14

1984 1988 1992 1996 2000 2004

-15

-10

-5

0

5

10

15

20

25

30

35

40Household savings ratio (LHS) Halifax house prices (RHS, %Y)

%%


UK trade balance and the real effective exchange rate

Sources: ONS, IMF

0

20

40

60

80

100

120

140

Q1 1980 Q1 1984 Q1 1988 Q1 1992 Q1 1996 Q1 2000 Q1 2004

-8

-6

-4

-2

0

2

4

6IMF real exchange rate (LHS)Current a/c deficit % GDP (RHS)Trade balance % GDP (RHS)

%


Slowing world trade growth

Source: IMF, Morgan Stanley Research Estimates

0%

2%

4%

6%

8%

10%

12%

14%

16%

2000 2001 2002 2003 2004 2005 2006

World export growth (%Y, goods & services)

Morgan Stanley forecasts


Morgan Stanley forecasts – central case

1506143013581290122211701116Money GDP(£ billion)

2.82.82.82.72.32.02.8GDP deflator

2.02.02.02.01.51.31.3Consumer prices

2.32.32.42.51.92.62.6Real HouseholdExpenditure

2.52.52.52.82.12.92.75Real GDP

2009-102008-92007-82006-72005-62004-52003-4Year-on-year (%)

Sources: Morgan Stanley Research estimates


Saving rates under central and ‘worst’ case

Source: ONS, Morgan Stanley Research Estimates

%

0

2

4

6

8

10

12

14

16

18

20

1987 1991 1995 1999 2003 2007

Whole economygross savingrate

National netsaving rate

H/H savingratio

H/H savingratio – Morgan Stanleycentral case

H/H savingratio – Morgan Stanley'worst case'

`

Morgan Stanley forecasts


Morgan Stanley forecasts – worst case

1437136813021246120111691116Money GDP(£ billion)

2.802.802.502.302.102.002.75GDP deflator

2.02.01.81.51.21.31.25Consumer prices

1.01.01.00.63-0.142.442.60Real HouseholdExpenditure

2.252.252.001.440.662.762.75Real GDP

2009-102008-92007-82006-72005-62004-52003-4Year-on-year (%)

Sources: Morgan Stanley Research


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The research analysts, strategists, or research associates principally responsible for the preparation of this research report have received compensation based upon various factors, including quality of research, investor client feedback, stock picking, competitive factors, firm revenues and overall investment banking revenues.

Stock Ratings

Different securities firms use a variety of rating terms as well as different rating systems to describe their recommendations. For example, Morgan Stanley uses a relative rating system including terms such as Overweight, Equal-weight or Underweight (see definitions below). A rating system using terms such as buy, hold and sell is not equivalent to our rating system. Investors should carefully read the definitions of all ratings used in each research report. In addition, since the research report contains more complete information concerning the analyst’s views, investors should carefully read the entire research report and not infer its contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. An investor’s decision to buy or sell a stock should depend on individual circumstances (such as the investor’s existing holdings) and other considerations. Global Stock Ratings Distribution (as of December 31, 2004)

Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count

% of Total IBC

% of Rating Category

Overweight/Buy 632 34% 249 38% 39% Equal-weight/Hold 880 47% 310 47% 35% Underweight/Sell 374 20% 99 15% 26% Total 1,886 658

Data include common stock and ADRs currently assigned ratings. For disclosure purposes (in accordance with NASD and NYSE requirements), we note that Overweight, our most positive stock rating, most closely corresponds to a buy recommendation; Equal-weight and Underweight most closely correspond to neutral and sell recommendations, respectively. However, Overweight, Equal-weight, and Underweight are not the equivalent of buy, neutral, and sell but represent recommended relative weightings (see definitions below). An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley or an affiliate received investment banking compensation in the last 12 months.


DisclaimersANALYST STOCK RATINGSOverweight (O). The stock’s total return is expected to exceed the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.Equal-weight (E). The stock’s total return is expected to be in line with the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.Underweight (U). The stock’s total return is expected to be below the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.More volatile (V). We estimate that this stock has more than a 25% chance of a price move (up or down) of more than 25% in a month, based on a quantitative assessment of historical data, or in the analyst’s view, it is likely to become materially more volatile over the next 1-12 months compared with the past three years. Stocks with less than one year of trading history are automatically rated as more volatile (unless otherwise noted). We note that securities that we do not currently consider "more volatile" can still perform in that manner.Unless otherwise specified, the time frame for price targets included in this report is 12 to 18 months. Ratings prior to March 18, 2002: SB=Strong Buy; OP=Outperform; N=Neutral; UP=Underperform. For definitions, please go to www.morganstanley.com/companycharts.ANALYST INDUSTRY VIEWSAttractive (A). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be attractive vs. the relevant broad market benchmark named on the cover of this report.In-Line (I). The analyst expects the performance of his or her industry coverage universe over the next 12-18 months to be in line with the relevant broad market benchmark named on the cover of this report.Cautious (C). The analyst views the performance of his or her industry coverage universe over the next 12-18 months with caution vs. the relevant broad market benchmark named on the cover of this report.Stock price charts and rating histories for companies discussed in this report are also available at www.morganstanley.com/companycharts. You may also request this information by writing to Morgan Stanley at 1585 Broadway, 14th Floor (Attention: Research Disclosures), New York, NY, 10036 USA.


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