For pretty much as far back as I can remember the best indicator of how investment markets will behave next year is how they behaved last year. Differences in detail were expected but broadly it was true. Over slightly longer terms the detail differences would grow in significance and quite major blips might occur but the basic world order would remain much the same.

Looking at investment commentaries from brokers and fund managers, this view is still prevalent. There might be major short-term concerns but we will weather the storm and soon things will return to their natural pattern. It is not clear whether they are just talking their book. It would certainly be good for their business if we were all piling into equities.

However if you examine the history of the stock market over the last century or so you very quickly realise how wrong that is. Certainly if you look at the past in terms of equity performance over successive quarter centuries it is hard to imagine how much more different these periods were from each other. One is left with only one certainty and that is change.

What is different about this current economic crisis is that apart from the two world wars it has rarely been so obvious that change is happening right now and that that change will be permanent.

Even in the realm of politics there is change. Obama has been elected President. The world needs him to be a good President but even ignoring that question, his election has proved that a black man can be President of the United States. As long as he does not make what is clearly a worse job of it than any previous President, that fact alone is of major significance, not only within the United States but also in the wider world, particularly in Africa.

Back in the UK the problem from an investors point of view is working out what the future will be. We have a choice,

1. A deflationary future with falling output, falling prices and falling standards of living.
2. An Inflationary future with rising prices, hopefully rising output in few years time and falling standards of living.
3. There is the third intermediate alternative of stagflation, rising prices, falling output and falling standards of living.

A Deflationary Future.
The proudest boast of recent governments has been their success in controlling inflation. However, despite that and Gordon Brown's stated concerns over deflation there is also a possible inflationary scenario.

The case for deflation is clear. The banking crisis has destroyed money on a large scale. Money has therefore become more difficult to get and with the resultant reluctance to spend, the only option if you want to sell your goods is to cut the price. If prices are falling the obvious thing for consumers to do is defer purchases, putting more pressure on prices and causing more price falls. In that scenario wages also have to fall because that is the only way to keep prices competitive.

Certainly the case for a deflationary future is strong. One of the reasons for inflation is that there is simply too much money chasing too few goods. Conversely if money is scarce prices tend to fall.

In such a situation it is difficult to raise money to start a business and in any event price are under constant pressure and profits are difficult to make. The economy contracts with growing unemployment.

It is certainly a horrifying scenario but there are problems with it. The theory obviously works in a closed economy or a virtually closed economy where most goods are produced locally and the market is the local market. The last time we had deflation in the 1920s and 30s the sterling zone was an empire covering a third of the world. Today the UK is effectively the sterling area.

An Inflationary Future
You only need to go down to the local supermarket to see that much of the food there is produced overseas. If foreigners do not sell to us they can sell somewhere else and food is not an optional purchase. There is therefore a reason why at least some prices will not fall by much.

Under the inflationary scenario prices rise because of sterling weakness despite the reduced supply of money. At the moment the priority is to prevent the economy collapsing and the government is cutting taxes, pumping money into the banking system with a view to pumping it into the wider economy and spending.

Strangely inflation has benefits. The falling value of Sterling makes British goods more competitive overseas stimulating the UK economy.

This is particularly important, as one of our major exports has been financial services because of the unrivalled expertise available in London and New York. However given recent events that reputation cannot be other than damaged. That means that we have to export something else and so our prices must be competitive. Devaluation makes that possible.

Another benefit of inflation and a depreciating currency is that the real value of the growing government debt declines with time. Not only that, the higher interest rates that would accompany higher inflation, increases tax revenues making the debt easier to service.

Admittedly that benefit is to the government. Savers and particularly the retired would see the value of their savings whittled away.

There is also a third more subtle benefit of inflation. That is for final Salary Pension Schemes. When inflation was 10% a year many leavers saw their preserved benefits whittled away due to inflation. The government therefore made schemes increase benefits in line with inflation up to 5% a year. Schemes were invested in real assets and those assets were more than keeping pace with inflation and so it didn’t seem too unreasonable for the schemes to give at least some protection to early leavers. Investment returns still exceeded the rate at which pensions increased by a substantial margin.

However, inflation fell well below 5% per annum and stock market returns fell in both absolute and real terms. Schemes were therefore fully compensating early leavers for inflation and having to pay for it out of reduced investment returns. When this was coupled with the government ceasing to give schemes back the basic rate tax credit on equity dividends, the result was the problems seen in the pensions industry today. These tax-credits were worth about £5Bn a year and probably more now. It is pretty obvious that if the government is not putting £5Bn a year into pensions, employers have to, or else members do not get their promised benefits. In practice employers are bearing the cost in many schemes but in others the members are paying through reduced benefits.

Clearly high inflation would help repair the situation for employers but at the cost of reducing the real value of pensions. However at least that loss would be more evenly spread but the effect will take time to come through after the recent period of low inflation.

In some ways deflation and inflation have similar effects, as both result in standards of living falling but inflation is politically easier.

Ultimately if we buy goods we have to pay for them with goods we produce. The uncomfortable truth is that as a nation we have been spending more than we have been earning on world markets. The only way for us to repair the situation is for us to spend less than we earn on world markets. That means a substantial fall in our standard of living by whatever mechanism is least painful.

Economic Outlook 1