UK Economics & Market Outlook

Ian Stewart +44 20 7996 1512 ian_stewart@ml.com

December 2001

Overview
l l l l l l

US, German and Japanese recessions underway; UK avoids recession Surveys provide only tentative evidence that the UK domestic economy is cooling Rate lows: US 1.5%; Eurz 2.75%; UK 3.5% Monetary policy works . . . strong 2002H2 recovery Buy UK domestic consumer plays Downside risks: US imbalances, Japanese banks, ECB inertia
Base Rates Lead UK Consensus Growth Forecasts
3.50

Consensus forecasts for UK GDP growth

3.00

ML Forecasts (Consensus)
2.50

GDP Growth RPIX inflation, end year Base rates, end year 10 year yields, end year

2000 3.0 2.1 6.0 4.9

2001F 2.3 (2.1) 2.0 (2.2) 4.0 4.7

2002F 2.2 (2.0) 2.5 (2.4) 5.0 5.0

6 2.00 7

1.50

Base rates, inverted and pushed forward 6 months (RHS)

1.00

Falling rates imply rising growth forecasts

0.50

10

0 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

11

Rolling average for current & next years consensus GDP forecasts for the UK (LHS) Base rate plot inverted and pushed forward 6 months (RHS)

Base rates falling

Markets Believe This is a Recovery

Cyclicals vs Defensive Stocks (UK)

300

Commodity Prices CRB Index

235 5.40 230 5.30

10 Year Bond Yield

280

225

5.20

220
260

5.10

215

5.00

210
240

4.90

205

4.80

200
220

4.70

195

4.60

200

190

4.50

185

4.40

180 J F M A M J J A S O N D J

180 J F M A M J J A S O N D J

4.30

2000 2001 Total returns: cyclicals / defensives Cyclicals = Mining, basic industries, general industries, cyclical consumer goods Defensives = Utilities, food retailing, non-cyclical consumer goods

2000

2001

2000

2001

The Feds Problem

US Short Rates, Long Rates

8

Laurence Meyer, 27.11.01: On the US outlook prior to 11th September: I expected growth to build only slowly and therefore expected the pace of recovery through the first half of 2002 to be disappointing.
30 year bonds

Fed funds

The response of financial conditions to monetary policy easing in this episode has been unusual, if not unique...[due to weakness in equities and dollar strength]...I believe that the financial shocks that have occured - including the shocks to equity prices and the dollar - have required monetary policy to move more aggresively than would otherwise have been the case. The implication of starting with an unusually low interest rate is therefore not to go slowly but to be respond more aggressively to any adverse shock

1 1995 1996 1997 1998 1999 2000 2001

11th September Collapses Growth Forecasts

Recession Newsflow
4500
3.50

G7 GDP Growth Forecasts

4000
3.00

3500

3000

2.50

2500
2.00

2000

1500

1.50

1000
1.00

500

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

0.50 89 90 91 92 93 94 95 96 97 98 99 00 01 02

UK press and newswire references to the word recession

12 month rolling consensus forecasts for G7 GDP growth

Consensus Forecasts for 2002 GDP Growth in:
Jan-01 3.5 1.9 3.2 4.1 2.4 2.6 Nov-01 0.7 -0.6 1.0 1.9 1.5 2.0 Change 2.8 2.5 2.2 2.2 0.9 0.6 Nov as % of Jan 20 -32 31 46 63 77

US Japan Asia Pacific Latin America Eurozone UK

Traditional Ingredients for Post-War Recession = Collapsing Optimism + Rising Inflation

UK
50 40

Manufacturing confidence

70

60 20

50

-20

40

Why Recessions Happen:

1. Inflationary excess (UK 1990-2) 2. Structure imbalances and failures (Japan 1990s) 3. Policy mistakes (Japan, Great Depression)

-40 30 -60

-80

Inflation (RHS)

20

10 -100

2.5% Inflation Target (RHS)

-120 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 0

= Recession = No Recession

80

US
NAPM

45

70

40

35 60 30 50 25 40 20 30 15 20

Inflation (RHS)

10

10

0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

Why Has the US Surprised on the Downside?

1. Collapsing Equity Prices

2. Surge in the Oil Price

3. 1999-2000 Rate Hikes

350

70

300

60

7
50

250

US
6 6

40

200

TMT
150

5
30

4
20

Total Market
100
10

Nominal
3

Euroland
3

Real
2 2

50 1998 1999 2000 2001 2002

0 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

1 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

January 1998 = 100

Why This Slowdown is Different . . . To a Certain Extent

Its Been Driven by Capex . . .

50 8
12

. . . And This Has Occured Despite Massive Rate Cuts

75

7 40

10

70

30

Household spending (RHS)

Real money growth

65

5 20 4

60

55

10

50

2 0 1 -10

45

-2

40

Capex (LHS)
-20

-4

NAPM survey

35

-1

-6

30

-30 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

-2

-8 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

25

US capex & household spending: % change over 4 quarters

= Recession

Natural Disasters Do Not Cause Recessions Japanese GDP Growth

8 7

US Natural Disasters
Hurricane Hugo Hurricane Andrew Northridge Earthquake 11th September Attacks
UCLA estimate

1989Q3 1992Q3 1994Q4 2001Q3

Cost, $Bn 17.8 63.9 74.8 14.0*

As % US GDP 0.2% 0.6% 0.7% 0.1%

January 1995 Kobe earthquake

3

-1

-2

-3 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Japan & US - Similarities and Differences

Some Similarities Equity Indices
1400

Scorecard: Japans Bust Compared to Americas

Feature Strong productivity, low inflation during the boom Rapid growth in stock prices Rapid declines in stock prices Rapid rise in real estate prices Real estate prices falling Japan Yes Yes Yes Yes Yes No ? Yes US Yes Yes Yes No No Yes Yes No Comment Japan was seen as a "new economy" in the 80s, the US in the 90s Nikkei rose 20%pa 1981-90. S&P500 rose 20%pa 1996-2000. 20m after its peak the US mrkt is down 29%; over the same period the Japanese mrkt fell 38% 1986-1989 capital gains on Japanese real estate = 300% GDP; 19952000 capital gains on US real estate = 100% GDP Over the last year rising house prices in the US have helped bolster consumption BoJ held rates for a year and half from the Summer of 1993 MOF tightened aggressively in 1996; US Treasury easing aggressively now Banks loans = 90% of Japanese GDP in 1991 & < 40% of US GDP

1370

1200

SAME
768

937 US

1000

800

600

323
400

Aggressive monetary ease Fiscal policy stimulative? Banks in trouble?

Japan
200

0 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

260

Capex 1980 = 100

US

Capacity Utilisation
120 115

240

220

110

SAME
Japan

200

SAME
Japan

105

180

100

160

95

140

90

120

85

100

80

80

US
75 70 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 77 79 81 83 85 87 89 91 93 95 97 99 01

60

10

Japan & US - Differences

Real Interest Rates
6 8 5

Unemployment, %
7

Real rates high in 1990-91

DIFFERENT
US

DIFFERENT
US

2 4 1

3 0

Unemployment unchanged 1990-92

Japan

-1

Japan
86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

-2

1 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

220

Real Estate Prices 1986 = 100

US

Banks vs Their Broad Market

140 130

200

180

DIFFERENT

120

DIFFERENT

US

110

100
160

90
140

80

120

70

Japan
100

60

50

Japan
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02

80 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

40

US & Japanese Banks sector relative 1988 = 100

11

US Outlook

Bull Case

Bear Case

l l l l l

Money Fiscal policy Inventories Market sentiment Low expectations

l l l l

Capex Debt and savings Asset prices Unemployment

12

Australia: Monetary Policy in Action

How Did Australia Manage to Weather the Asian Crisis?

15
8.00

With Massive Monetary Ease

105

7.50

Crisis starts
10

Aus $

100

Korea
7.00 95

6.50

90

Rates
6.00 85

Australia
5.50 80

5.00

75

-5
4.50 70

-10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

4.00 1993 1994 1995 1996 1997 1998 1999 2000 2001

65

13

Recessions Require Consumer Capitulation

Components of UK GDP % change yoy

15

10

Recessions Since 1970 Manufacturing Profits Capex GDP 10 10 6 3

Consumer spending

Capex

Profits
-5

Exports Manufacturing

-10

-15 1998 1999 2000 2001

14

Why Has the UK Consumer Held Up?

Real, Post Tax Earnings Growth
8

1. BoE activism: base rate cuts. Down at least 200bp this year.
4

2. Lower taxes. Down by 9.0bn in April 01, equivalent to 3p off the basic rate. 3. Windfall gains: 1bn from Friends Provident; 1.5bn from Scottish Life; all due in 2001H2

-2

-4

-6 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

Nominal earnings deflated by the Tax and Price Index

15

UK Leading Indicators
Slope of the Yield Curve
400 400 11 300 300 10 200 200 9

Real Broad Money Growth

11

10

Consumer Confidence

10

10 5 9 0 0 5

+ve for

8 100 100

8 -5 -5

7 0 0 6 -100 -100 5 -200 4 -300 -300 3 -400 -400

7 -10 -10

consumer

-15

-15

-200

4 -20 3 -25 -25 -20

2 -30 -30

-500

-500

-600 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

-600

0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

-35 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

-35

CBI Business Confidence

40 40
40

Chambers Survey: Orders

12
40

OECD Leading Indicator

12 10 10

30

30
30 30

20

20

10

10

20

20

-ve for

0
10 10

-10

-10 2 2

corporates

-20

-20

0 -30
-10 -10

-30

-2 -40 -40
-20 -20

-2

-4

-4

-50

-50

-60 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

-60

-6
-30 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 -30

-6 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

16

Consumer Expenditure Scorecard: Expenditure Strong, Only Tentative Signs of Softening

Consumer Confidence
10 30 25 5

Retail Sales: John Lewis vs Official Data

Retail sales volumes (RHS)

25

Car Sales: % Change 3m/12m

October: +21.7%

GfK

20 20 20 10 6

15 5

-5

15

-10

-10 10 4

10

-15

-20

-20

-30

-25

-40 0

John Lewis

3 0

-5

-30

MORI
90 91 92 93 94 95 96 97 98 99 00 01 02

-50

-35

-60

-5 1997 1998 1999 2000 2001 2002

-10 J F M A M J J A S O N D J F M A M J J A S O N D

GfK: Based on answers to 5 questions on the outlook/ performance of the economy/own households finances & willingness to make big ticket purchases MORI: Economic Optimism

John Lewis weekly retail sales: 6 week moving average

2000

2001

80

RICS Price Balance & Housing Reservations

Number of Mortgage Approvals

40 30 25 30

Manpower Survey: Recruitment Intentions

20

60

RICS

40

3m/12m

20
20

15

10 10
0

3m/3m
0

-20

-40

HBF

-5 -10 -10

-60

-20 -15

-80 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

-30 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

-20 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

Balance of housebuilders from monthly HBF survey reporting an increase in: House Prices, nsa Purchasers making an initial deposit (reservation) on a new house, nsa

Number of mortgage approvals after cancellations and remortgaging

Balance of employers in all sectors planning to raise employment

17

Consumer Output Scorecard: Service Firms More Bearish

New Orders
75
80

Business Optimism in the Service Sector CBI Survey Data

60

70

65

40

60

Construction

20

Retail (12%)

55

50

-20

Services
45
-40

Orders falling
40

Manufacturing
-60

Financial services (6%)

Business services (10%) Consumer services (10%)

35 1997 1998 1999 2000 2001

-80 1993 1994 1995 1996 1997 1998 1999 2000 2001

Balance of firms expressing greater optimism about the economic situation

18

Ultimately, Unemployment Follows the Cycle

Unemployment Follows Rates
11 20

Components of ONS Lagging Indicator for the UK

1. Adult unemployment. 2. Manufacturing employment. 3. Manufacturing capital expenditure. 4. Engineering orders. 5. Manufacturing inventories

18 10 16 9 14 8 12

US unemployment, rate %
7 10

8 6 6 5 4 4

Fed funds, pushed forward 2 years (RHS)

3 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04

Fed funds rate, pushed forward 2 years (RHS) US Total Unemployment Rate SADJ

19

Fiscal Policy Will Support UK Growth in 2002

Government Spending: % Change Year on Year
4.75%

Cyclically Adjusted Public Sector Net Borrowing as a % of GDP Change in Fiscal Stance: (+ve = Fiscal Ease)
Nov 99 Nov 00 Mar 01 Nov 01
PBR = Pre-Budget Report Source: HM Treasury
2.0%

00-01 0 +0.8 +0.2 -0.1

01-02 0 +0.5 +1.1 +1.9

02-03 +0.3 +0.6 +0.6 +0.8

03-04 +0.3 +0.8 +0.8 +0.3

04-05 +0.1 0 0 -0.2

3.0%

Up sharply The Fiscal Stance

1
3

Ease: Anthony Barber

Ease: John Major

HMT forecasts
-1

Ease: Gordon Browns plans

-2 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05
-1

Chart shows general Government consumption expenditure, the national accounts measure of current expenditure which excludes capital spending and accounts for about 20% of GDP Source: HM Treasury

HMT forecasts Tightening: Norman Lamont, Ken Clarke, Gordon Brown

86 88 90 92 94 96 98 00 02 04 06

-2

-3

Tightening: Geoffrey Howe

70 72 74 76 78 80 82 84

-4

Chart shows the change between fiscal years incyclically adjusted public sector net borrowing as a share of GDP: This represents the simplest way of showing the change in the fiscal stance. Source: HM Treasury

20

Debt is a Worry in the UK

Ratio of Household Expenditure & Business Investment to GDP

68 16

The Burden of Debt

3.60 1.25 35

Income Gearing: Interest Payments as a % Profits / Income

66

15

3.40

64

Household spending to GDP (LHS)

Corporates (LHS)

30 1.20

14

3.20

25
13 62 12 60

3.00 1.15

Average
20

Corporates

2.80

1.10
11

2.60 15

58 10

2.40

56

Business investment to GDP (RHS)

65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03

2.20

Consumers (RHS)
88 89 90 91 92 93 94 95 96 97 98 99 00 01

1.05 10

Average Consumers

54

2.00

1.00

5 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02

Ratio of gross debt to corporate profits (LHS) Ratio of gross debt to consumers gross disposable income (RHS)

Interest payments as % of: Corporates gross profits Consumers disposable income

21

UK Capital Stock Doesnt Look Overbuilt

Capacity Utilisation
140
US

90

Average

120

85

80

Capital spending has accelerated in the UK in recent years but unlike the US - there is no clear evidence that the UK is suffering from an overbuilt capital stock

100

75 80
20 year low

70
UK

60
Average Average

65

40

60

20

55

0 70 72 74 UK (LHS) US (RHS) 76 78 80 82 84 86 88 90 92 94 96 98 00 02

50

22

No Rerating of Long Run Growth Prospects for the UK

Consensus Estimates for Long Term GDP Growth
4.50
Japan was 4.1%

4.00

3.50

The fall in long run expectations for Japanese GDP growth has clearly been unhelpful for the Japanese economy and equity market in recent years

US is 3.2%

3.00

UK was 2.6%

2.50

US was 2.5%

UK is 2.4%

2.00

Japan is 2.0%

1.50

1.00 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Consensus forecasts from Consensus Economics. Figures show for each year and for each country the prevailing consensus forecasts for average GDP growth rates 5-10 years ahead

23

UK Inflation - The Best is Past, But Limited Upside Risks

Inflation boosted March-June by higher petrol & food prices; depressed in September - December by falling petrol prices Goods and utility prices (=33.4% of RPI) have trended up, pushing up core inflation. Inflation will benefit from lower output, import and commodity price pressures. But we see RPIX inflation edging up to 2.5% by the end of 2002 on firm domestic demand and a tight labour market.

24

Inflation Drivers Changing

Core Inflation Has Troughed

4.00 3.40 3.20 3.50 3.00 3.00 2.80 2.50 2.60

Ex-Petrol & Food Inflation Worrisome

RPIX excluding food & energy

2.00

RPIX

2.40

2.20 1.50 2.00 1.00

2.5% Inflation Target (RHS)

HICP

RPIX
1.80

0.50 1.60

0 1993 1994 1995 1996 1997 1998 1999 2000 2001

1.40 1996 1997 1998 1999 2000 2001 2002

25

Goods vs Service Inflation

Two Big Downward Pressures on RPIX Inflation are Receding (Weight in RPI Basket)
3

The Changing Composition of Inflation (Weight in RPI Basket)

5 20

High street goods prices (27.1%)

Services (35.8%)

15

3
0

10

-1

Utility prices (6.5%)

-2

All Goods (48.8%)

-3

0
-4

-5

-1
-5

Petrol (RHS) (4.5%)

1996 1997 1998 1999 2000 2001 2002

-10

-6 1997 1998 1999 2000 2001

-2

-15

Goods prices exclusing food, petrol and tobacco

Above breakdown excludes mortgage interest payments, Council Tax and depreciation which accounts for 10.9% of the RPI by weight

26

Big Picture Lead Indicators of Inflation

Whole Economy Capacity: Output Gap
5 4 55
-8

Whole Economy Capacity: Current Account Deficit

Average Current account

55

Output gap

50

-6

50

-4

0 40 -2
0 -2

40

-4

Average

30
2

30

-6
4

-8

20
6

20

-10
8

-12

-14 -15 65 67 69 71 73 75 77 79 81 83 85 87 89 91

Inflation (RHS)
93 95 97 99 01

10
10

Inflation (RHS)
70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00

10

12

60

Labour Market Capacity: Skill Shortages

55

45 40

Monetary Policy: House Price Inflation

Average House price inflation

55

50

50

50

40 40

30

30

40

Skills shortages
20 30 10

20

10 30

-10

Average Inflation (RHS)

70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00

20
-10

20

-20 10
-20

-30

-30

Inflation (RHS)
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00

10

-40

-35

27

How Much Scope For Downside Surprises on UK Inflation?

UK Inflation
95 98 97

Inflation forecasts are below target

4.00

4.00

3.80

3.80

3.60

3.60

3.40

3.40

3.20

3.20

3.00

3.00

2.80

2.80

2.60

2.60

2.40

2.20

2.00

96 2.5% inflation target

1994 1995 1996 1997

99

01 00

02

2.40

2.20

2.00

1.80 1998 1999 2000 2001

1.80

Limiting the scope for pleasant surprises for the bond market

9.50

10 Year Bond Yields

9.50

9.00

9.00

8.50

8.50

8.00

8.00

7.50

7.50

7.00

7.00

6.50

6.50

6.00

6.00

5.50

5.50

5.00

5.00

4.50

4.50

4.00 1993 1994 1995 1996 1997 1998 1999 2000 2001

4.00

10 year gilt yield

Inflation Expectations & Bond Yields Barring a hard landing inflation expectations probably dont have much further to fall
11 10

Fund Managers expectations for inflation

100

90

80

70

60 8 50 7 40

30

10 year bond yields

20

10

4 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

10 year gilt yields (LHS) ML/Gallup Fund Managers Survey: % of UK Fund Managers expecting higher inflation in 12m time (RHS)

28

 Outlook
The rebound in in 1996 represented a recovery from post-ERM under-valuation US Growth Shock Has Been of Surprisingly Small Benefit to the Euro

130

Trade Weighted 1990 = 100

2.20

US/Euroland GDP Growth Forecasts and $/Euro (RHS)

GDP 1999

0.80

125

2.00

0.90

120
1.80

115
1.60

GDP 1997 GDP 2000

1.00

110
1.40

105
1.20

1.10

100
1.00 1.20

95
0.80

GDP 1998

GDP 2001
1.30

90

85

De-rating of

Re-rating of

0.60

80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01

0.40 1996 1997 1998 1999 2000 2001

1.40

29

The UK & EMU

80 70 60 50 40 30 20 10 IN

% of Voters Who Want to Leave/Stay in the EU

O UT

Yield Curves: 29th August 1997

UK Germany

E E CRe fe re ndum 7%In; 3 3%O ut) 0 (6

19 93 19 94 19 96 19 97 19 98 19 99 20 00 20 01

19 75 19 77 19 80 19 83 19 87 19 90 19 91 19 92

Source: Bloomberg

UK & Danish Attitudes to EMU

25 20 25

Yield Curves: 27th November 2001

20

Danish referendum, September 2000 -6%

Germany

10

10

UK

-10

Danish voters

-10

-20

-20

-30

-30

-40

-50

UK voters

-40

-50

-60 1999 2000 2001

-60

UK Guardian / ICM survey: If there were to be a referendum, wouldyou vote to join the Single European Currency, or would you vote not to join? Chart shows % replying join minus % replying not join

Source: Bloomberg

30

Copyright 2000 Merrill Lynch, Pierce, Fenner & Smith Limited (MLPF&S). Issued by Merrill Lynch, Pierce, Fenner & Smith Limited which is regulated by the Securities and Futures Authority Limited. The information herein was obtained from various sources; we do not guarantee its accuracy. Additional information available. Neither the information nor any opinion expressed constitutes an offer to buy or sell any securities or options or futures contracts. MLPF&S and its affiliates may trade for their own accounts as odd-lot dealer, market maker, block positioner and/or arbitrageur in any securities or options of this issuer(s). MLPF&S, its affiliates, directors, officers, employees and employee benefit programs may have a long or short position in any securities or options of this issuer(s). Foreign-currency-denominated securities are subject to fluctuations in exchange rates that could have a positive or adverse effect on an investors return upon the conversion into local currency of dividends or interest received, or proceeds from the sale of such securities. In addition, investors in securities such as ADRs, whose values are influenced by foreign currencies, effectively assume currency risk.

31