On October 20, the government will announce huge public spending reductions. These will be controversial and there have already been threats of major industrial unrest in protest, which I believe are unavoidable. Those who want to wait until economic recovery is "established" are offering false hope. The more we delay cutbacks, the bigger the debts to be cut. The bottom line is that we have been living beyond our means for several years and UK public spending levels are unaffordable. We can not rely on strong growth to overcome the problem, especially in light of demographic realities.
In 2011, the first baby-boomers reach age 65 and thereafter millions more come up to retirement. But their pensions are inadequate. Government policy encouraged borrowing and discouraged saving, failing to ensure the baby-boomers set aside sufficient savings for the future. Unless more keep working, economic growth will weaken.
What does all this mean for our finances? Savers have suffered over the past 18 months as interest rates have stayed near zero to fight the recession. This is great for banks and borrowers, but investors are not keeping pace with inflation. Latest figures show consumer prices rising over 3 per cent and retail price inflation nearer 5 per cent. Investors desperately need to improve returns, but this is tricky and may mean taking bigger risks. Markets have been kind this year, giving the government the benefit of the doubt that it will tackle the budget deficit. Despite high inflation, bonds have done well. However, this may not last. Gilts could come under pressure from either unrest that forces spending cuts to be watered down, or from persistently high inflation which is currently being ignored as "temporary" but may be more long-lasting.
Gold, commodities and inflation-linked gilts have soared but still offer some inflation protection. The stock market also often does well in times of inflation. I would concentrate on companies with good dividend yields, high-margin manufacturers whose product prices are largely unrelated to their manufacturing costs, or strong, stable brands that enable firms to raise prices.
However, the most important rule is diversification. With so many risks out there, markets will be nervous, especially once the deficit cuts bite, or if inflation fails to fall sharply soon. A spread of investments, across different asset classes, can offer some protection against the various extreme outcomes - but expect a bumpy ride along the way.
