Equity markets can give investors hope during tough times
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By Barry Riley | Fri, 12/04/2013 - 15:42
How can savers and investors dodge the fallout from Chancellor George Osborne and the UK government's "remedy" for our financial woes?
We know the problems are mounting for the UK economy when official inflation targets are being abandoned and the country's AAA credit rating has been downgraded. As savers and investors we must adapt, however reluctantly, or we will suffer expensive penalties.
This is an age of illusion, leading to disillusion. When politicians become desperate, they no longer accept basic, tried and tested principles - that people should be encouraged to save, for example, or that only sustainable public spending objectives should be pursued.
Our savings and pension pots become piles of loose money that can be raided; and, secretly, behind closed doors, the D-word begins to be whispered - default. No wonder a pressure group called Save Our Savers has been formed.
We investors must protect ourselves. First, we must switch from monetary assets (deposits and bonds) to real assets (such as equities or property) to escape the worst effects of rising inflation. Second, we should shift the focus of our investments outside the UK, to avoid some of the effects of the debasement of the currency.
There are ominous signs of trouble ahead. The Bank of England has abandoned its 2% inflation target in favour of "flexibility". Vote-hungry politicians across Europe decry what is labelled "austerity" by their spin doctors when what they are really opposing are fiscal honesty and prudence.
However, for all the talk of cuts, UK Treasury spending continues to rise. In January I wrote that the loss of the AAA credit rating was inevitable.
The West is facing a fundamental democratic crisis. Parties win power at elections by wooing the electorate with promises of higher public spending and reduced taxes. They are always at risk of embarking on a path towards fiscal collapse and bankruptcy as a result.
Since World War II, this slippery slope has generally been avoided through the escape route of economic growth, which provides extra employment and raises government revenues. Europe and the US were, for decades, very competitive in the global economy. Since the 1990s, however, that competitiveness has been lost to the developing world, especially China. The growth escape route has been closed off.
One likely response will be attempts to stimulate growth by abandoning the principles whereby wealthy societies seek to protect their lifestyles and environments. Planning controls will be scrapped, employment protection rules will be torn up, and new roads, railways, airports and nuclear power stations will spread across an increasingly "fracked" UK landscape.
It is against this grim background that the current political, economic and financial drama is playing out in the UK. The Office for Budget Responsibility, the tame economic forecasting agency set up by the Chancellor, George Osborne, three years ago to rubber-stamp the Treasury's rose-tinted forecasts, has had to abandon the notion that growth will soon return to 3% a year.
The Bank of England has been demoralised by the appointment of a foreigner, the Canadian Mark Carney, as governor from July. Meanwhile, the bank's Monetary Policy Committee has become seriously split.
Financial markets are now more badly distorted than at any time since World War II. Prices and interest rates are no longer primarily set according to fundamental factors such as profits, creditworthiness or inflation.
Instead, they depend on a flood of loose money created mainly through quantitative easing (artificial price setting by central banks) in the US, Japan and the UK. The Japanese government is the latest to adopt an inflation target, after years of deflation. The Tokyo equity market has surged as a result.
Anomalies abound. For example, one symptom of all this official manipulation is that the outstanding financial opportunity currently available to UK citizens is to fix a mortgage for five years at 3% (although only if they can afford a deposit of 35% or 40%). This is thanks to the Funding for Lending Scheme (FLS) launched by the Bank of England last July. We can now see that it was designed to pump up house prices before the next general election in May 2015.
The FLS is enabling mortgage lenders to reduce their funding costs for several years ahead. They therefore no longer need to compete seriously for retail deposits, as a result of which rates on two-year fixed deposits have collapsed by about one percentage point since last summer. This amounts to another attack on conventional savings. Only borrowers and spenders are rewarded by the politicians in these conditions.
This latest squeeze on interest rates does mean, though, that the short-term outlook for house prices has improved.
As joyful headlines in the Daily Express show, house price inflation is regarded as good and will win votes for the Conservatives at the next election. Beyond that, however, it remains true that house prices are too high on fundamentals - especially in relation to personal incomes. The coming bubble will be a brief one.
The other asset class benefiting recently from monetary laxity has been equities. When bonds began to reach seriously overvalued levels last year at the same time as money was still being pumped out by various governments, especially our own, the big investors began to rebalance their portfolios. This has not yet amounted to the "great rotation" I mentioned in January, but there has been a marked shift from bonds to equities.
Economic growth prospects have not yet improved in a way that might make equities more attractive, but inflation has begun to accelerate globally. In the UK the Bank of England has declared its readiness to accept inflation above 2% indefinitely.
Fixed-interest bonds on tiny yields have therefore become less attractive to investors, even when they are prepared to set aside the risks these carry of government debt restructuring or default, which become more serious every time the eurozone crisis reignites. The insolvency "parcel" is being passed around from Greece to Spain and then on to Italy. Might France be next?
Sterling weakness is the other consequence of monetary laxity. It's good news for investors with shares in the big international companies that dominate the FTSE 100 (UKX) index, because most of their business is conducted overseas in foreign currencies, but it drives up domestic prices.
The Bank of England knows this and has relaxed its inflation target. But this is not an easy fix. Fear is growing of a 1930s-style currency war, as the major economic blocks engage in beggar-my-neighbour attempts to gain competitiveness at the expense of trading partners.
In some ways the UK has a trading advantage compared with the eurozone member states in having its own currency. But a national currency must be managed responsibly and sustainably or it will come under speculative attack, as the pound did just 20 years ago on Black Wednesday.
These are scary times. The UK government has deliberately penalised savers for choosing low-risk investments. We must invest more heavily in equities, property and foreign currency assets. We may be surprised and pleased at how high these risky assets rise. But setbacks will come and many will not enjoy being such a long way away from their risk comfort zone.