The year has been a tough one for Britain. With the government still talking a big game on ‘austerity’ measures, it seems that every other week we’ve seen protests erupt against public-sector pension cuts, student fees, or bankers, the City, and capitalism in general. Given that most of us have seen our cost of living grow far more rapidly than our wage packets this year, perhaps the biggest surprise is that we haven’t seen even more social unrest.
The bad news is that all of this looks set to continue. Last week’s autumn statement from the chancellor George Osborne was a litany of gloom. Yet the most miserable thing about it is that it probably wasn’t gloomy enough. The chances are that Britain faces many more years just like this one, if not worse. That’s why you need to take steps to protect your wealth now. We’ll get to how to do that shortly.
But first, why is the outlook so bleak? When the coalition government was formed in the wake of last year’s election, Britain faced the biggest shortfall in the state finances it had ever seen. Both the budget deficit (the annual gap between tax and spending) and our national debt (what the country owes in total) were spiralling out of control. That left the government pushing through what were viewed as drastic austerity measures. Yet even so, Osborne still thought it would take until the end of the current parliament in 2015 to get to a position where we could start to cut into the national debt.
Unfortunately, that forecast was too optimistic. It now turns out that the government will still be spending more than its tax take until well after the next election, even though the public spending cuts will also be deeper, and go on for longer. In fact, the government is going to have to borrow £111bn more than it had expected by 2016.
On official figures, that means that Britain’s national debt-to-GDP ratio will reach 78% by 2014-2015. Calculate that on the same basis as the eurozone’s figures are worked out and the ratio will, in fact, be 90%. That compares with the current year’s national debt-to-GDP ratio forecast for Spain, for example, of around 70%.
What’s tripped the chancellor up is economic growth – or rather, the lack of it. Britain’s independent budget watchdog, the Office for Budget Responsibility (OBR), has slashed its current year growth forecast to 0.9% from the previous 1.7%. Next year a mere 0.7% is on the cards, compared to the previous prediction of 2.5%. Because growth has been much lower than expected, tax revenues have disappointed too. Meanwhile, fewer jobs have been created, which in turn means higher welfare benefit payouts.
Why is growth so weak?
“Most of the weakness can be explained by an external inflation shock constraining real household consumption,” says OBR chairman Robert Chote. Put in plainer terms, households are spending roughly as much as the watchdog had expected. But because inflation has come in higher than forecast, that spending is buying fewer things at higher prices. As a result, living standards have suffered their tightest squeeze since World War II.
On top of that, it seems our national ‘output gap’ is smaller than the OBR had reckoned. In other words, the British economy was permanently damaged by the recession. Industries and businesses that only made economic sense during the days of cheap credit are now dead and gone for good. So the overall scope for recovery after the 2008/2009 Great Recession has been cut.
That takes us to the real problem for Osborne – not to mention the rest of us: that even now, the OBR is probably being too optimistic. From 2013 onwards, it expects annual growth to come in at 2% or more. If these forecasts fall short of the mark, then Britain will turn out to be in an even deeper hole than it already is. And that seems likely to happen.
The most obvious risk is the situation in the eurozone. The region is currently the destination for around half of Britain’s exports. With a renewed European recession now a racing certainty – regardless of what happens to the euro – those OBR growth estimates look ripe for slashing.
As a result, we could see a vicious circle develop, says Vicki Redwood at Capital Economics. “There is clearly a risk that the OBR sees the recovery slowing more sharply than it expected. This would make the structural budget deficit look even worse.” In other words, if growth slows even further, the gap between the government’s tax income and its spending will get even bigger, and Osborne will be forced to cut even harder.
In a nutshell, then, we could face many years of increasing austerity. That will continue to squeeze consumer spending, which accounts for two-thirds of GDP. That will be bad news for almost any business that makes its money from the domestic economy. In turn, that means that the dole queues are likely to lengthen. And the outlook for property prices will remain poor.
Why we need to keep cutting
So why stick with austerity? Because Britain is at the mercy of its international creditors. It can take a long time for lenders to lose patience with a heavily indebted country. But as the crisis in the eurozone shows, once they do run out of faith, the market can turn on a sixpence. The yield on a country’s debt will rise – ie, the value will drop – which means that the cost of raising more money to service the national debt will climb too. When you still owe the best part of £1trn, as Britain does, every 1% extra in borrowing costs adds almost £10bn a year to the budget deficit. That would make matters even worse.
The good news is that for now Britain is seen as something of a safe haven. We can borrow money for ten years at roughly 2.3%. That’s almost as low as Germany – in fact yields on UK government bonds (gilts) briefly dropped below German bunds around the time of Osborne’s autumn statement. This all compares with the near-7% that Spain had to pay to borrow money last month.
But let’s not be fooled. So far, there’s been one big reason why UK gilt yields are so low – the Bank of England. Britain is not in the eurozone, which means it still has its own currency. So the Bank is able to indulge in quantitative easing (QE), which is magicking up money out of thin air in order to buy gilts. To date, QE totals £275bn. Such a gorilla of a buyer in the market must, in the short-term, drive gilt prices up, and so push yields down.
In the market’s eyes, that means the immediate risk of default is lower than in the single currency, where heavily indebted individual countries can’t do QE. In other words, at least investors know they’ll get their money back if they lend to Britain, even if inflation has reduced its value in the meantime. In Europe, the risk is that they won’t get their money back at all. This worry will only grow as pressures in Europe mount. Credit ratings agency Standard & Poor’s has just warned that 15 eurozone states, including Germany, have been placed on “downgrade watch”. That could mean lower bond ratings, which could lift eurozone borrowing costs across the board.
But the big danger for Britain is that debt contagion could soon cross the Channel. At some stage the eurozone crisis will be resolved – one way or another. Then the global ‘bond vigilantes’ might start scrutinising Britain’s books. That could prove a tipping point, because the total debt picture for the country as a whole looks very scary indeed.
Britain’s massive debt burden
Company, household and government indebtedness equates to nearly 300% of GDP, according to Morgan Stanley’s latest number crunching. That’s bad enough. But throw in what Britain’s banks owe and the overall total comes to almost 1,000% of our annual output. That dwarfs every other major economy. It’s more than twice the European average. It shows how much of our past growth has been based on nothing better than building up more and more debt. And it spotlights the growing dangers of investing in this country today.
Sure, those bank obligations aren’t on the public balance sheet at the moment. But we’ve seen before what happens when the system goes pear-shaped. Just as happened three years ago, the state would have no choice but to bail out the banks if another credit crunch took hold. So taxpayers would be on the hook once more.
Where does this leave the outlook for ten-year gilts? At present levels, they look like a rotten deal. That 2.3% yield compares with Britain’s present inflation rate of at least 5%. In other words, UK bondholders are losing some 2.7% of the value of their investment in ‘real’ – ie, inflation-adjusted – terms every year.
Yes, the cost of living may drop a bit if our economy dips or falls back into recession. But it’s unlikely to fall significantly. The Bank of England has just pumped another £75bn into the system, and is widely expected to ramp up its QE even more next year. But the extra cash isn’t being lent into the economy. Instead, it’s being punted in the financial markets, driving up prices of stocks and commodities. Meanwhile, it’s also keeping sterling weak. That’s likely to push inflation higher again, which will have two adverse effects. Over time, there will be more upward pressure on gilt yields as investors tire of losing ‘real’ money. And the squeeze on consumers will go on as the rising cost of living continues to outstrip wage growth.
To sum up, the British economy will struggle for years to come. That’ll be bad for both consumers and businesses over the longer term. Neither our government nor our citizens have the scope to increase their spending by taking on more debt. The state’s coffers are already full of holes, which could widen further. So gilts, the usual refuge at such a time, now look like a lousy investment.
Is there any hope at all for UK Plc? There could be. But it depends on whether or not our politicians have the bottle to act. The trouble is that “Britain’s debts are unsupportable without sustained economic growth, and the economy is currently aligned against growth”, says Dr Tim Morgan at Tullett Prebon. “All macroeconomic options have been tried and have failed. Radical solutions are required if a debt disaster is to be averted. The only remaining options lie in ‘supply side’ reform.”
We’re talking here about a huge cut in government regulation. This would allow investment and job creation, free from the “complication and bureaucratic meddling forced on businesses” by the last government, says Morgan. A simpler tax system would help, too. The overall aim would be to “offer the public some offset to the depressing economic conditions that are now beginning to unfold”. But even were this to happen, it would take time to kick in. So for stockmarket investors the next several years are set to be very tricky indeed. We look at the best ways to protect your wealth below.
Tips to ditch; survivors to stock up on
Times might be tough now for Britain, but we’ve been here before. Just under three years ago we spotlighted a number of ‘bad news buys’ that we reckoned would do well out of the credit crunch. While the latter has since morphed into a longer-term gloomy outlook, the basic backdrop – subdued consumer spending – remains the same. So how’s that list from February 2009 looking now? Which of these shares still seems right to buy today, and what other stocks could you now consider?
One key to surviving austerity Britain is not spending unless you have to. That plays nicely into the hands of takeaway king Domino’s Pizza (LSE: DOM). But it’s served up a total return – ie, including re-invested dividends – of more than 100% since February 2009. That compares with around 50% for the overall market. On the current p/e of 22, any good news is factored into the price, so we wouldn’t chase this one any higher.
Lack of cash will be another enduring theme. This is where doorstep lender Provident Financial (LSE: PFG) comes in. Provident Financial has made investors 55% overall in the same period, even though it’s one of the market’s most ‘shorted’ stocks (ie, sellers expect the price to drop) on fears that bad debts will rise. But business is still good and, on a p/e of 11, and a near-7% prospective yield, shareholders are being well rewarded for taking the risk of investing in a money lender.
Pawnbrokers are other beneficiaries of cash-strapped Britain. Since February 2009, H&T Group (LSE: HAT) has almost doubled investors’ money in total return terms, while Albemarle & Bond (LSE: ABM) has gained 75%. On a current year p/e of below 11 and near-4% prospective yield, the latter is still worth holding.
So far, more companies have managed to survive the slump than looked likely three years ago. That’s why our tip for business recovery specialist Begbies Traynor (LSE: BEG) hasn’t worked out. The firm prepared itself for a rush of work that didn’t materialise – and the shares have since slumped by around three-quarters. But if a wave of corporate insolvencies now hits, Begbies is still well placed to take advantage. It’s high risk, but this could be a buy for the brave.
For those who prefer a quieter life, it’s worth looking again at one of our old favourites. National Grid (LSE: NG/) owns the high-voltage electricity transmission network in England and Wales and operates the system across Great Britain. The group also owns and operates Britain’s high-pressure gas transmission system. These are regulated activities unlikely to be hurt by more austerity. Recent half-year figures were good. The interim dividend has been hiked, as promised, by 8%. On a p/e of 12, and with a prospective yield of almost 6.5%, there’s plenty for shareholders to look forward to.
Finally, there was a smidgeon of pre-Christmas cheer from last week’s autumn statement. Britain is going to up its spending on infrastructure. That should provide a bit of a boost to the construction industry. To take advantage, consider Balfour Beatty (LSE: BBY), Britain’s biggest builder. It’s involved across the civil engineering spectrum. That’s not been a great place to be lately, so it’s little wonder the company has been out of favour with investors – in fact, the shares have undershot the overall market by a third in the last four years. But that has left Balfour Beatty very cheap. The balance sheet looks sound: there’s no net debt. On a p/e of just seven, and a prospective yield of 5.3%, this stock could be worth tucking away.
Category: Market updates