Savers and investors must gear up for war

Published by Barry Riley on 06 January 2010.
Last updated on 06 January 2010

People fencing

Savers and investors must periodically cope with economic adversity. In 2010 they will be engaged in trench warfare against governments in general and the UK government in particular, which will be fighting its own battle for survival.

We will witness the mother of all wars between savers and borrowers.

In the short run, governments have a simple answer to coping with a financial crisis: throw taxpayers' money at it. Market intervention during 2009 has been on a colossal scale.

Short-term interest rates are being kept low and UK government bonds have been bought by the Bank of England to the tune of £200 billion.

Safety-minded savers have been robbed. In effect, a confiscatory tax has been imposed on deposit interest, with a huge benefit transferred to banks and mortgage borrowers - one reason shops were busy before Christmas.

This amounts to a desperate attempt by the Treasury to salvage the solvency and retain the votes of homebuyers, millions of whom have paid recklessly high prices for property during the past five years.

The policy of quantitative easing - pumping money into the economy through purchases of government bonds - was supposed to boost the economy by reversing the effects of the credit crunch. However, that was always pure fiction, as the real goal was to reduce the cost of government debt and push the sterling exchange rate lower. Meanwhile, the UK economy has continued to slide.

People who have saved for their pensions, and companies that have supported pension schemes, have been treated appallingly. The recovery in equities has now helped them somewhat, but pensioners depend, above all, on fair bond yields, which have been manipulated downwards by the Treasury, squeezing annuity rates and increasing pension scheme deficits.

Sterling could crash at any time and it is only being sheltered by the fact that the US dollar is scarcely more attractive.

As a holding operation, quantitative easing worked in 2009, but a side effect has been the boosting of the stockmarket, and even house prices, rather than the economy. 

The government may yet totter through to the general election before the next stage of the crisis. After that, though, all bets are off. The big credit-rating agencies are poised to downgrade UK sovereign debt. Only the assumption that another government will adopt seriously prudent fiscal policies, starting in June or July, is restraining them.

The political polling season is about to begin. Recent survey results have fluctuated and there is everything to play for. The simple outcome would be a working majority for the Conservatives.

It has already promised an emergency Budget within 50 days of taking power, and it would have every incentive to raise taxes and cut public spending as quickly and brutally as possible. There would be no point waiting.

Its first Budget would make Sir Geoffrey Howe's notorious 1981 Budget look positively benevolent.

A second possibility, though, would be a Tory victory with a narrow majority. This would usher in a 1970s-type scenario in which the government would focus on winning a second election within a year or two. Punches would be pulled, action deferred and further risks taken.

There is also a third, possibly even worse, outcome: a hung parliament. It is hard to see the credit-rating agencies deferring a downgrade for long in the event of such an outcome. As in the 1970s, the rescue team from the International Monetary Fund (IMF) would be put on red alert.

The IMF manages power-sharing problems routinely on the Continent, but the fact that the UK has no recent experience of true coalition government would pose additional difficulties.

Risk scenarios   

Let's look at the main risk scenarios the UK faces.

First, tax rises might include increases in the rate of income tax, loss of pension relief and a sharp rise in capital gains tax, as the government seeks to cash in on the recent boom in equities.

Second, a sterling crisis could lead to inflation, which is going to rise in the next few months in any case. And, as in the 1970s, the next government is going to be strongly tempted to tolerate inflation at the level of 10% to 15% over several years. This would erode the Treasury's debt burden and validate current house prices.

Third, the quantitative easing strategy ends, and is probably reversed, and short-term interest rates rise sharply. Depositors will be pleased - until they receive their tax demands - but fixed income investors, whether in gilt-edged or corporate bonds, suffer capital losses.

A fourth possibility is that an equities bubble develops. Prices are now discounting global economic growth on a scale that is unlikely to materialise. They have been pumped up by monetary boosts that will be phased out during 2010.

International equities at least offer a hedge against sterling depreciation, whereas domestic shares linked, say, to the high street or financial services, do not.

One final scenario is that our problems are dwarfed by a much bigger global 'accident'. An accident involving China poses the greatest danger. Certainly, whether China booms or crashes will determine what happens to commodity prices, including the oil price.

The rush back into emerging market equities in 2009 leaves many investors exposed.

Winning ways

Investors and savers would be wise to adopt a general investment principle of looking at underlying values. In 2009, underlying value was the main attraction of equities that had been heavily sold off the year before.

Today, the bargain basements are less well stocked, but there is still scope in gold as long as the leading economies appear determined to debauch their currencies. However, government bonds look overpriced, with 2010 threatening to be a year of sovereign debt crises around the world.

Hedge fund managers will be aiming to duck and dive through 2010 to dodge the various risks and exploit transient opportunities. The rest of us can only diversify to reduce the damage and make the occasional portfolio adjustment as assets re-enter buying ranges.

Available currency hedges, in addition to gold, include euro-denominated government bonds (but stick to Germany, France or the Netherlands). The best inflation hedges are index-linked gilts, although they represent insurance policies rather than opportunities.

Risky equities, which have been so profitable since last March, could easily suffer a sell-off in 2010. Safer short-term deposits may be less heavily penalised. Floating-rate mortgages will not be the household budget boosters that they have been, with the Bank of England base rate down at 0.5%.

Modern governments tend to penalise prudent savers and encourage borrowers and spenders.

Politicians see rapid economic growth as a quick and easy answer to their problems. But if a strong new government can stabilise the country's finances, or a weaker one is forced to, the pain will be worth it. Savers could win something back from borrowers.

A crisis in public finances in 2010 might sound scary, but there will be winners as well as losers.

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