Rough seas ahead?

By Justin Urquhart Stewart 07:42 22- Jun -2009

Justin is away this week - not unwell, he has gone yachting - so he has asked me to step in to cover his weekly column.  Justin is not being held hostage by Somali pirates off the Horn of Africa, but on a corporate event somewhere in the English Channel, no doubt singing for his supper and entertaining a captive audience with his red braces and large stock of anecdotes.

Good for Justin I say - he should enjoy it while he can, as the going is unlikely to be plain sailing for UK plc for the next few years.  We are seeing some encouraging signs of a recovery right now, but they are tentative and it remains to be seen just how many of these so-called green shoots will survive the impending storm of tax increases and government spending cuts we will soon be suffering.  Add to this the increased regulation we have all been told to expect and the outlook for the green shoots starts to look a little bleak. 

Mohamed El-Erian, chief executive of Pimco, the large US investment house, has coined the phrase the New Normal[1] for the situation we face.  The recovery and future growth is going to be burdened by higher tax, lower social spending, the dead hand of government and a dysfunctional financial system.  As a result we should expect lower long term growth, higher volatility in the investment markets and higher inflation risks over the medium to long term.

Right now we are living on borrowed time.  The government is forecast to run a deficit of over £100 billion this financial year, escalating to £178 billion next year.  Now that is a lot of zeros and commas when you write the numbers out in full, so to give you an idea of the magnitude of the deficit, it is nearly as big as the amount the government is forecast to raise from income tax and corporation tax next year.  In other words, the government would have to nearly double income tax and corporation tax to cover this deficit, all other things remaining equal.

I say we are living on borrowed time at present as no political party is going raise taxes, or hold out the prospect of spending cuts, a few months before a general election - not even our present government.  But make no mistake - a combination of higher taxes and real spending cuts are just around the corner, coupled with greater red tape, regardless of which party forms the next government.

How do your investment portfolios cope with this world of the New Normal, a world with high tax, high regulation, low growth, high volatility and high inflation?  There are three answers in my opinion and they are diversification, diversification and diversification.  No single course of investments will perfectly protect you against all risks, which is why many investors may prefer to hand over responsibility to professional money managers, who will have their work cut out in the New Normal world.

To cope with the risk of increased inflation and volatility you may want to hold a broad array of internationally diversified investments so that problems in one country do not overwhelm your portfolio.  You might want to include some inflation hedges as index linked bonds and perhaps a smattering of real assets (as opposed to paper assets) such as commodities and maybe property, but only when the time is right.  To cope with the greater uncertainty in the world financial markets you may also be drawn to high grade government bonds or even bonds issued by high grade corporations although, as Justin would point out, inflation is ‘kryptonite’ to bonds, so these investments will need to be watched carefully.

Equities could well have lower returns and greater volatility going forward, but by most metrics they look relatively cheap.  Not as cheap as they were in previous market bottoms, in 1932 or 1974, but they do look good value for longer term investors. Again we would recommend a broad international spread and perhaps a bias to the fast growing Asian markets.

Six months ago we were bracing ourselves for a financial hurricane that had the potential to sink us all.  We are now in the hurricane but we have managed to stay afloat, albeit with some frantic bailing by the government.  Going forward the outlook will be unsettling for many investors, but those that are well diversified and have patience could be well rewarded.

***

And finally, as we near the end of the exam season the Times On-Line has some great exam blunders that I hope my own son and heir managed to avoid.  In my experience, the answer to the religious studies question does not seem wide of the mark.

Classical Studies
Question: Name one of the early Romans' greatest achievements.
Answer: Learning to speak Latin

Biology
Question: What is a fibula?
Answer: A little lie

Geography
Question: What are the Pyramids?
Answer: The Pyramids are a large mountain range which splits France and Spain

Religious Studies
Question: Christians only have one spouse, what is this called?
Answer: Monotony

Have a good week.

Peter Sleep
Senior Investment Manager
Seven Investment Management Limited