A year of austerity looms in 2010

December 23, 2009

david-kuo_motley-foolthumbnail-David Kuo is director at the Motley Fool. The opinions expressed are his own.-

If you thought 2009 was as bad as things will get, then think again: 2010 could be worse. It is likely to be a year of enforced austerity with both the government and households making obligatory cuts to their budgets.

High on the government’s agenda will be reducing the Budget deficit, if the UK is to avoid the embarrassment of having its sovereign debt rating cut by rating agencies. This will have a knock-on effect on households, which could see their disposable incomes slashed by hikes in both direct and indirect taxes.

There are two possible ways for the government to reduce the Budget deficit. The first is to increase tax revenues and the second will be to slash expenditure – both of which will have an adverse impact on the economy. There is a third, which is to raise revenue through the sale of state assets. These may include the Royal Mint, the nations stake in part-nationalised banks, and anything else the Chancellor might find lurking at the back of the wardrobe.

It should, therefore, not come as a huge surprise to households next year if the government takes a larger proportion of our income through tax hikes. It is unlikely that businesses will be burdened with increased taxes (unless you include banks), so wage earners will shoulder most of the responsibilities. Consumers have already been warned of the reversal in the 2.5 percent cut in VAT on 1 January 2010, and it would not be unreasonable to expect VAT to rise to 22.5 percent or even as high as 25 percent afterwards.

Controversially, London shares may perform well next year even though the economy may remain in the doldrums. That’s because companies that generate a vast proportion of their income overseas dominate the FTSE 100 index. As a consequence, The Motley Fool still believes the FTSE 100 index could hit 7,000 points next year if businesses can achieve their profit targets next year.

Some of the bests performing London shares are likely to be those that have significant overseas exposure. So, look it may pay to look east for the best picks. These are likely to include banks such as Standard Chartered and HSBC. African insurer Old Mutual may also do well, as could British American Tobacco that sells its cigarettes to almost everywhere but the UK.

China will continue to grow – it can’t afford not to. This therefore bodes well for commodity companies such as Anglo American, BHP Billiton, and Rio Tinto. Meanwhile, the rise of the Asian consumers, who are expected to unleash their spending powers next year could benefit upmarket retailers. Burberry, which already generates a quarter of its income in Asia, may be worth keeping an eye on.

The rise in global stock markets will provide some investors with a difficult choice – to continue pushing up the price of a non-income generating commodity such as gold or invest in income-generating assets such as shares. The latter could prove the more attractive investment, which could spell an end to gold’s extraordinary run.

Interest rates may push higher too, given that there are already signs of inflation. The increase in November’s CPI to 1.9 percent from 1.1 percent in October would suggest that inflation is far from benign. Under normal circumstances, the base rate would be at least 2 percent if inflation is to be kept in check.

The rise in interest rates may make gold investors to think twice before piling more money into the yellow metal. Currently, it costs almost nothing to hold gold given that interest rates are effectively at zero. But that may not be the case if interest rates rise.

If there is one lesson we can take away from the global turn it is that the economies are cyclical. We have has ten years of fat, and now it is time to prepare for ten years of lean. And if anyone should ever tell you that they have beaten the “boom and bust” economic cycle, just nod politely and rebalance your portfolio.

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