Britain is back to its old bad habits – expect trouble ahead

I suspect George Osborne will enjoy Christmas this year.

His political standing is on the up, and he can point to some encouraging economic data. For example, inflation fell to 2.1% in November, while unemployment has fallen to its lowest level in four and a half years.

However, I can’t get too optimistic.

Sure, the UK may grow at a decent rate in 2014, but our economy still has some serious problems that are far from cured.

And that means we could be storing up big trouble for the future…

Spending all our savings is not a sustainable national business model

The problem that worries me most is our current account deficit, which soared from £6.2bn in the second quarter of this year to £20.7bn in the third quarter. In other words, we imported way more goods and services than we exported.

Compare to national income, the deficit has now hit 5.1%. That’s the highest level since 1989. If you remember, 1989 was the peak of an economic boom. In 2013, the current account deficit has hit a new peak just as the economy is beginning to recover.

So you have to ask: if we were to get three more years of economic growth from here, how bad would the deficit be in 2016?

This ballooning deficit is at least partly due to increased spending by UK consumers. Your average Brit isn’t earning any more cash from his job. So he’s just gone back to his old ways and is spending rather than saving.

Household spending rose 1.7% in the last quarter, yet wages rose by only 0.2%. And the household savings ratio has fallen from 6.2% to 5.4% this year.

Now to be fair, I can live with a short-term drop in saving if that means we get some extra consumption that can firmly move the UK economy into growth again. But this isn’t a viable long-term strategy.

If we do spend more now, we’ll have to save more in the medium term. If you don’t save, you can’t invest. And we desperately need to invest if we are to achieve Osborne’s apparent aim of ‘rebalancing’ the economy away from the City.

Simon Wells, chief economist at HSBC, is on the money here: “The composition of growth still looks unsustainable in the long term with trade dragging on activity and the household savings rate falling further.”

Interest rate hikes could come sooner than anyone thinks

I’m also worried about what might happen when interest rates rise.

As Vince Cable said on yesterday’s Andrew Marr Show, rising house prices in London may force Bank of England boss Mark Carney to increase the base rate earlier than many folk expect.

Higher rates could push up sterling, which would make life tougher for exporters. The Bank of England has already hinted that it feels a little concerned about sterling’s strength.

More importantly, it would also increase pressure on many borrowers. Figures from the Bank show that if mortgage costs rose by just 2.5 percentage points, then the proportion of people spending more than 35% of their income on home-loan repayments would double from 8% to 16%.

What’s more, personal debt is on the rise again, and has hit a new peak of £1.43trn.

With so much debt sloshing around, a return to more normal interest rates will be a challenge for many of us. You can’t assume that it’s all bound to go smoothly.

As Hamish Macrae put it in yesterday’s Independent on Sunday: “people are becoming too optimistic… there are still a lot of adjustments to be made”.

Make sure you don’t have all your eggs in one British basket

So what does this mean for your investments?

Well, as I said at the beginning, I suspect the wheels won’t fall off the economy in 2014 – mainly because Osborne will be keen to keep the party going in the run-up to the next election. The government’s ‘Help-to-Buy’ scheme should help in that respect. (This is the scheme that helps borrowers find sufficient cash to pay a chunky deposit on a new home.)

As a result, the UK stock market will probably perform reasonably well next year, and stocks connected to the housing market look especially appealing. One such share is Travis Perkins, which Phil Oakley analysed recently.

But further out, things could get hairy. So if your portfolio is predominantly invested in the UK, it makes sense to start diversifying now. And don’t wait too long – because I may have got my timing wrong.

Japan represents a very exciting opportunity and I also think that some emerging markets could do well over the next five years.

Whatever you do, don’t fall into the trap of thinking that a few decent economic numbers mean that all our problems are solved. The UK has serious problems and they’re not going away, as my colleague John Stepek said in a recent MoneyWeek cover story. (If you’re not already a subscriber, subscribe to MoneyWeek magazine.)

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