The British economy looks stronger by the day.
Growth forecasts are being revised upwards while inflation remains low.
That’s practically the holy grail for UK policymakers. A low-inflation British boom!
You see, UK economic recoveries traditionally hit the wall because inflation takes off. Then interest rates have to rise to choke off inflation.
So George Osborne must be delighted. Can he now sustain this low-inflation recovery?
Sadly, I fear not. The UK still has some serious structural problems. You can still make money from Britain’s pre-election rebound – but you have to be careful…
A typical British recovery – built on house prices
The NIESR, a well-respected think tank, has just raised its GDP growth forecast for the UK this year from 2% to 2.5%. Capital Economics is even more upbeat, predicting 3% growth this year.
That would be impressive. It’s significantly faster than its long-term trend rate of 2.5% a year.
But here’s what I’m worried about: this recovery has too much in common with previous UK recoveries. As the NIESR says: “We expect consumer spending to remain the key driver of the recovery in 2014 and 2015, supported by continued buoyancy in the housing market.”
In other words, rising house prices are boosting confidence. The classic British mindset is kicking in. It goes something like this: “Next door has just sold their house for £300,000. That means our house must also be worth £300,000. We’re rich! Let’s go and buy a new car and then go on holiday.”
And the main reason why house prices have picked up has been loose monetary policy – low interest rates and money-printing.
Now, unlike some MoneyWeek writers, I think that loose monetary policy was the right response to an emergency in 2009. But that’s all it was – a response to an emergency. It hasn’t solved our more deep-rooted problems. In fact, some of those problems have got worse.
There’s still too much debt across the economy. We have a weak financial system, too few world-beating businesses, and a painfully large trade deficit.
And on top of those ‘classic’ British problems, we face turbulence in emerging markets and the threat of deflation in the eurozone. Neither of which will help UK exports.
So when loose monetary policy ends – which it has to, at some point – we’ll realise that we haven’t made as much progress as we had hoped.
Of course, Osborne will do his level best to keep the economy growing nicely until the next election. And Bank of England boss Mark Carney seems keen to help – there’s no sign that he wants to push up interest rates any time soon.
So I suspect the recovery could continue for a while yet. But it won’t be as long-lived as many people currently think. My best guess is that we’ll see a slowdown in late 2015 or 2016. I just can’t see how you can sustain the current recovery when it’s built on flimsy foundations.
Potential triggers for the slowdown include an end to ‘Help to Buy’, a rise in the base rate, turbulence in China, a further deterioration in the trade deficit or the spillover from a renewed eurozone crisis.
How to take advantage of the pre-election surge
Now, I reckon canny investors can still benefit from the recovery. All of the government’s efforts will be focused on keeping it going until May 2015 at least.
So if you want to invest in the UK for a year or two, you could consider housebuilders or some retailers: especially those selling furniture and homeware goods.
You won’t find many pure UK-focused businesses in the FTSE 100 as most FTSE companies are large global businesses with substantial operations abroad.
You’re much better to look in the mid-cap FTSE 250.
But there are also plenty of UK-focused businesses on Aim as well, which you can now pop in your individual savings account. In fact, I highlighted five great Aim-listed companies in this week’s MoneyWeek magazine cover story: Five Aim stocks worth a flutter. (If you’re not already a subscriber, you can read the piece and get your first three issues of the magazine free here).
Remember, if you pick quality stocks, you shouldn’t suffer too badly even if the slowdown comes earlier than I expect.
But here’s the really important point: don’t get carried away and think that most of our problems are solved, and that we’re now at the beginning of a nice five-year boom. We’re not.
There’s going to a lot more volatility in the economy and the stock market. Prepare for a bumpy ride and a slowdown within the next couple of years.
• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.
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