Rough Seas Ahead?

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 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...

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

For previous editions of our Weekly Update, please click here

This article represents a personal and light-hearted view from Director, Justin Urquhart Stewart of Seven Investment Management Limited, and is based on current financial news and events around the world. Its content should not be used for investment purposes and you should contact an independent financial adviser before making any investment or financial decision. Seven Investment Management Limited is authorised and regulated by the Financial Services Authority. Member of the London Stock Exchange. Head office: 23 Austin Friars, London EC2N 2QP. Telephone 020 7760 8777. Registered in England and Wales number 4092911. Registered office: 3 More London Riverside, London SE1 2AQ.