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									The Green Budget

The Economic Outlook
January 2005
Professor David Miles +44 20 7425 1820 david.miles@morganstanley.com

         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.
The Economic Outlook

     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.



                                                   Please refer to important disclosures at the end of this presentation
Economic growth less variable than in the past
             11
                                     UK GDP (volume, Y%)
              9

              7

              5

         % 3

              1

             -11957    1966   1975       1984            1993               2002
             -3

             -5

         Source: ONS




                                            Please refer to important disclosures at the end of this presentation
Inflation has been low and stable since the mid 1990’s
           30
                               RPI - inflation                     CPI - inflation
           25

           20

         % 15

           10

            5

            0
             1957       1966         1975        1984              1993                2002



          Source: ONS




                                                        Please refer to important disclosures at the end of this presentation
Annual growth and inflation by decade
                                                                   1957-        1965-           1975-          1985-          1995-
                                                                   1964         1974            1984           1994           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                               2.6           2.3             2.4            2.2            0.7
       (standard deviation of annual change)a

       Variability of retail price inflation                        1.6           3.8             6.3            2.5            0.8
       (standard deviation of annual change)a


       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




                                                                          Please refer to important disclosures at the end of this presentation
UK per capita output catches up with its European peers

           % of US               1980                 1990                 2000                     2003

               UK
                                   66                  67                    72                       74
            France
                                   77                  75                    73                       72
          Germany a
                                   80                  78                    72                       70
              Italy
                                   74                  74                    71                       71
               US
                                  100                 100                   100                      100

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




                                                                      Please refer to important disclosures at the end of this presentation
Cycles, Capacity and Trend Rate of Growth

     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.




                                              Please refer to important disclosures at the end of this presentation
Hodrick-Prescott measures of spare capacity
         9%
                              1600               HP 100                  HMT
         7%
         5%
         3%
         1%
        -1%
        -3%
        -5%
        -7%
        -9%
          1980Q2          1984Q2        1988Q2    1992Q2    1996Q2             2000Q2             2004Q2




       Source: ONS and Morgan Stanley Research




                                                           Please refer to important disclosures at the end of this presentation
Hodrick-Prescott and Christiano-Fitzgerald (CF) measures
of spare capacity
           9%
                                1600              CF                   HMT
           7%
           5%
           3%
           1%
          -1%
          -3%
          -5%
          -7%
          -9%
            1980Q2         1984Q2        1988Q2   1992Q2   1996Q2            2000Q2             2004Q2




      Source: ONS and Morgan Stanley Research




                                                           Please refer to important disclosures at the end of this presentation
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 trend
     a % of potential output




                                                                             Please refer to important disclosures at the end of this presentation
Employment and unemployment headcounts (million)
        3.5                                                                                                            29

                                    Unemployment (LHS)                Employment (RHS)
                                                                                                                       28
        3.0

                                                                                                                       27
        2.5
                                                                                                                       26
        2.0
                                                                                                                       25

        1.5
                                                                                                                       24

        1.0                                                                                                            23
           1984    1986      1988     1990     1992     1994      1996      1998       2000       2002       2004


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




                                                                    Please refer to important disclosures at the end of this presentation
Employment and participation rates (%)
          82.0                                                                                                  76
                                      Participation (LHS)           Employment (RHS)
          81.5                                                                                                  75
          81.0
                                                                                                                74
          80.5
          80.0                                                                                                  73

      %   79.5                                                                                                  72
                                                                                                                      %
          79.0                                                                                                  71
          78.5
                                                                                                                70
          78.0
          77.5                                                                                                  69

          77.0                                                       68
              1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004


       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.




                                                                         Please refer to important disclosures at the end of this presentation
Ratio of output to the stock of capital
      0.60
                                   Fitted trend                   Actual
      0.56


      0.52


      0.48


      0.44


      0.40
         1987          1989        1991        1993        1995        1997          1999          2001          2003



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




                                                                            Please refer to important disclosures at the end of this presentation
Net national saving rate as % GDP
           8
                                                National net saving rate
           7

           6

           5
    %      4

           3

           2

           1

           0
               1987      1989         1991   1993     1995       1997           1999           2001           2003



        Sources: ONS and DataStream




                                                                 Please refer to important disclosures at the end of this presentation
Treasury and Morgan Stanley trend growth estimates

                                                    MS Benchmark case
                                      HM Treasury   (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




   Source: ONS and Morgan Stanley Research




                                                           Please refer to important disclosures at the end of this presentation
Treasury forecasts for key economic variables
       Year-on-year growth (%)             2003            2004          2005                2006               2007
                                         (outturn)
       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                 3.50           4.50           3.00               3.00               2.50
       consumption
         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)




                                                                    Please refer to important disclosures at the end of this presentation
The Economic Outlook

     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.




                                              Please refer to important disclosures at the end of this presentation
Income to house price ratios relatively high
        5.0
                         ODPM - House Price to Income Ratio (based on lenders data)
        4.5

        4.0

        3.5

        3.0

        2.5

        2.0
              1969    1973        1977        1981     1985   1989        1993         1997          2001


         Source: Office of the Deputy Prime Minister




                                                               Please refer to important disclosures at the end of this presentation
Mortgage payments still relatively affordable
              16
                                                    Debt servicing as % post-tax income
              15
              14
              13
              12
         % 11

              10
               9
               8
               7
                 1988       1990       1992        1994       1996       1998         2000          2002         2004


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




                                                                          Please refer to important disclosures at the end of this presentation
House prices and the saving ratio
          14                                                                                                           40
                      Household savings ratio (LHS)                Halifax house prices (RHS, %Y) 35
          12
                                                                                                                       30
          10                                                                                                           25
                                                                                                                       20
            8                                                                                                          15
      %     6                                                                                                          10 %
                                                                                                                       5
            4                                                                                                          0
                                                                                                                       -5
            2
                                                                                                                       -10
            0                                                                                                          -15
             1984              1988             1992             1996               2000                  2004



      Source: Bank of England, ONS and Morgan Stanley Research



                                                                    Please refer to important disclosures at the end of this presentation
UK trade balance and the real effective exchange rate
                                     IMF real exchange rate (LHS)
      140                            Current a/c deficit % GDP (RHS)                             6
                                     Trade balance % GDP (RHS)
      120                                                                                        4

      100                                                                                        2

       80                                                                                        0

       60                                                                                        -2      %

       40                                                                                        -4

       20                                                                                        -6

        0                                                                                  -8
       Q1 1980    Q1 1984       Q1 1988   Q1 1992   Q1 1996       Q1 2000           Q1 2004


            Sources: ONS, IMF




                                                        Please refer to important disclosures at the end of this presentation
Slowing world trade growth
                      16%              World export growth (%Y, goods & services)

                      14%

                      12%                                       Morgan Stanley
                                                                forecasts
                      10%

                       8%

                       6%

                       4%

                       2%

                       0%
                               2000      2001     2002   2003   2004     2005        2006
     Source: IMF, Morgan Stanley Research Estimates




                                                                  Please refer to important disclosures at the end of this presentation
Morgan Stanley forecasts – central case
        Year-on-year (%)       2003-4     2004-5    2005-6   2006-7         2007-8        2008-9        2009-10

       Real GDP               2.75        2.9       2.1      2.8           2.5           2.5            2.5

       Real Household         2.6         2.6       1.9      2.5           2.4           2.3            2.3
       Expenditure


       Consumer prices        1.3         1.3       1.5      2.0           2.0           2.0            2.0

       GDP deflator           2.8         2.0       2.3      2.7           2.8           2.8            2.8

       Money GDP              1116        1170      1222     1290          1358          1430           1506
       (£ billion)



       Sources: Morgan Stanley Research estimates




                                                                   Please refer to important disclosures at the end of this presentation
Saving rates under central and ‘worst’ case

          20                                                                             Whole economy
          18                                                                             gross saving
                                                               Morgan                    rate
          16                                                   Stanley
                                                               forecasts                 National net
          14                                                                             saving rate
          12
      %   10                                                                             H/H saving
                                                        `                                ratio
          8
          6
                                                                                         H/H saving
          4                                                                              ratio – Morgan Stanley
                                                                                         central case
          2
          0                                                                              H/H saving
               1987     1991       1995       1999          2003    2007                 ratio – Morgan Stanley
                                                                                         'worst case'
                 Source: ONS, Morgan Stanley Research Estimates




                                                                      Please refer to important disclosures at the end of this presentation
Morgan Stanley forecasts – worst case
        Year-on-year (%)         2003-4    2004-5    2005-6    2006-7         2007-8          2008-9         2009-10


       Real GDP                 2.75      2.76      0.66      1.44           2.00           2.25            2.25


       Real Household           2.60      2.44      -0.14     0.63           1.0            1.0             1.0
       Expenditure


       Consumer prices          1.25      1.3       1.2       1.5            1.8            2.0             2.0


       GDP deflator             2.75      2.00      2.10      2.30           2.50           2.80            2.80


       Money GDP                1116      1169      1201      1246           1302           1368            1437
       (£ billion)


       Sources: Morgan Stanley Research




                                                              Please refer to important disclosures at the end of this presentation
Disclaimers
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Global Stock Ratings Distribution
(as of December 31, 2004)
                        Coverage Universe           Investment Banking Clients (IBC)
                                            % of                      % of    % of Rating
Stock Rating Category       Count           Total     Count      Total IBC      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
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Disclaimers
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                                                                                            Please refer to important disclosures at the end of this presentation
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                                                                                           Please refer to important disclosures at the end of this presentation

								
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