My weekly waffle, plus some decent links from around the web.

I am sure everyone is getting fed up with me blowing my own trumpet about predicting ongoing growth in the UK, against the backdrop of general despair at the start of the year.

But I’ve got to admit that this week’s release of a 0.8% GDP growth figure for the past quarter for the UK made me chuckle.

As the Motley Fool recounted:

Consensus estimates were of a modest 0.4% growth in the economy in the third quarter (Q3) of the year. Instead, GDP growth came in on Tuesday morning at a surprising 0.8%, a level predicted by only a handful of economic forecasters.

What’s more, growth was broadly spread, with construction, services and manufacturing all posting strong gains; and only the agriculture, forestry and fishing sector failing to increase output.

The contrast with the gloom expressed in the media couldn’t be more stark.

Not all the media, dear Fools, if we can count humble Monevator amongst such ranks.

The real question is what happens next? As ever, it’s difficult to say – certainly more difficult than most of the knee-jerk gloomy predictions of the past 18 months made out – but I’ll have a bash at risking my own track record.

In my view, it was pretty clear that the UK would grow this year. The signs were that the slowdown had plateaued, and the banks were at the least on life-support. Add that to spectacularly low interest rates and a weak pound, and it would have taken – literally – a bomb for UK GDP to slip below zero in my view (or possibly the break up of the EU, though that never seemed immediately likely).

The consensus now is this 0.8% GDP growth represents a last fling before the storm of pain to come from the spending cuts next year.

I doubt it:

• State spending is actually increasing in nominal terms – the idea that money will drain from the economy is nonsense. Services may suffer, but business won’t fall off a cliff.

• I don’t see any reason for interest rates to rise presently, and low interest rates are pumping millions into middle-class mortgage owners’ pockets every month. Provided they’ve kept their jobs, many in the key 35-55 demographic have never had it so good.

• At worst, I think unemployment will be flat. This displacement of jobs from the public sector to the private sector is very credible.

I don’t doubt the private sector is better at allocating capital and finding useful productive work for workers to do than the public sector. The only dispute for me is the extent to which we need to redistribute the gains from private enterprise to limit inequality (I think we should, up to a point) and how much the State should step in to do work private companies can’t or won’t (certain aspects of health care, for example, and the upkeep of our nuclear missiles).

So I see most of the cuts as highly desirable. Indeed, if I look at my 10 things I didn’t want to pay taxes for any more article from May, I see the Coalition is making inroads into most of them. I’d take some credit, except that most of these cuts were so blindingly obviously required, it’d be more shocking if they weren’t enacted.

Anyway, my prediction is for another year of growth from here, perhaps below trend at say 2% GDP if there’s another Euro-wobble, but with the potential to surprise to the upside. The key domestic risk I see is a second slump in the property market, which does seem to be listing again. That would be great for me, but it wouldn’t be great for UK GDP.

If you’re a UK equity investor, the balance of risk and reward seems even clearer. Insignificant domestic interest rates and potential QE, awful yields on bonds and cash, and 70% or more of UK company earnings coming from overseas is all hugely supportive for further stock market growth.

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I previously explained how to create your own Guaranteed Equity Bond (GEB) using a cash savings account and a cheap FTSE index tracker fund. I also outlined why you might want to.

In summary: My proposed DIY GEB is cheap, transparent, safe, and flexible. In contrast the GEBs flogged by banks and advisers are opaque, potentially expensive, and built around derivatives.

Today’s post offers some follow-up ideas, so please do read the original DIY Guaranteed Equity Bond article first.

Haven’t you been too cautious?

Yes, deliberately so.

My proposed DIY GEB returns your full capital after five years — even if the stock market goes to zero – due to you keep enough money in cash to guarantee it.

But the stock market is unlikely to go to zero. And if it did, I doubt you’d be able to retrieve your cash, or find shops to spend it in.

I deliberately kept things simple and 100% secure for the introduction, but there’s a way to tweak the risk to your own taste:

• Work out how much you need to split your lump sum between cash and the stock market tracker to guarantee capital protection, as detailed in part one.

• Decide the worst-case return you think is likely from the stock market over five years (remember to include dividends, at around 3% a year for the FTSE All-Share).

• Apply your worst-case return to your stock market allocation, to see what your tracker would be worth in five years if the stock market did that badly.

• Since in your worst case you expect your tracker fund to be worth whatever number you just worked out, you can subtract that from your cash savings target after five years.

• Recalculate the (lower) amount you need to put into cash to aim to get to no loss of capital after five years when incorporating the stock market returns, and put the (now higher) amount of spare money into your stock market tracker.

Confused? You can see why I left it out of the introduction!

A riskier GEB: A worked example

Some numbers should make it easier to understand (and also show how it is a fudge).

From part one’s example of a £5,000 lump sum, we worked out we needed to save £3,918 in cash at 5% in a tax-free ISA for five years to ensure we still had £5,000 at the end.

The rest, £1,082 went into the stock market. If that went to zero, we’d still have £5,000 due to the cash.

But let’s say in our worst-case scenario, we think that after reinvested dividends of c. 3% per year, the money in the tracker fund won’t fall by more than one half over five years.

• One half of £1,082 is £541.

• So our new cash target after five years is (£5,000-£541) = £4,459.

Playing around with the compound interest calculator shows we need to save £3,492 at 5% in the cash ISA to ensure we get £5,000 back from adding together our new cash target (£4,459), and our worst case stock market return (£541).

This gives us a higher £1,508 to invest in the stock market tracker fund – some 50% more than before — and so capture more reward if the stock market rises.

Caveats and catches

Anyone of a mathematical bent will appreciate that half of £1,508 is actually more than £541. Hence in our worst case of a 50% return for stocks, we’d actually have more money then we need.

If you suspect we could therefore repeat the above process of recalculating the cash amount required over and over for diminishing gain every time, you’re right.

There’s probably an equation I’ve forgotten from my A-Levels that can work it out recursively, or maybe you could write a quick computer program. But personally, I’d do it just once, then consider the surplus cash a margin of safety on the stock market doing even worse than you think possible.

On that note, this riskier DIY GEB is no longer capital guaranteed, because stocks could do worse than you can imagine. But GEBs created by the banks also fail in certain circumstances, so the riskier DIY GEB is no worse.

Also – and crucially – you’re not forced to sell out after five years with the DIY GEB if you find you’re stuck in a bear market in year five. You can wait. In a conventional GEB, you’d have to follow whatever rules you signed up to when your time was up.

What’s a safe worst-case scenario? Well, 50% is the biggest minimum return I’d predict, just to be on the safe side. I’m pretty sure 30% would cover all historical eventualities, but I haven’t worked it out.

A few more FAQ-style thoughts

In the process of inventing this DIY GEB (though I’m sure I’m not really the first to think of it) I asked myself some questions, which I’ll answer now.

Hopefully I cover most queries, but please do post your thoughts in the comments below.

Where can I get a 5% fixed rate ISA?

At the time of writing, you can’t. Use whatever ISA rate you can get. I fully expect to see rates well above 5% in the fullness of time, too.

Why does the cash have to be in an ISA?

I’m assuming a tax-free return, to keep the maths simple and the DIY GEB feasible. If you have say £50,000 to invest you could do a similar thing using cash savings outside of an ISA, and a (lower) net savings rate. When interest rates return to normal higher levels this might be attractive, but currently you’re not going to have much money left spare for the stock market.

Why not use gilts instead of cash?

You could do this, particularly when gilts are actually offering a decent yield. In fact, gilts are ideally suited to the fixed time horizon aspect of the DIY GEB. You could buy a five-year gilt, say, locking in a running yield as the gilts move to redemption. However, there’s one big flaw to gilts, which is that you can’t re-invest your gilt income without paying a dealing fee, like you can with cash interest, and you’ll likely be limited to minimum deal sizes, too. If you’re that investor with £100,000 to make into a DIY GEB, gilts may be worth exploring though, especially when the yields are higher.

Why not use corporate bonds / prefs / offshore bonds, etc?

These securities sometimes offer higher income (so letting you put more in stocks) but they’re not risk-free like cash, or even nearly risk-free gilts. Feel free to experiment with weird and wonderful fixed interest / stock market fund combos, but understand you’ll be taking on far more risk as you do so. (At least you’ll be able to see the risk, mind, compared to a bank’s GEB).

I think the Snodgrass and Bunderberry GEB is a better bet!

No doubt it is. I’m not saying my proposed DIY GEB is going to make you more money than a bank’s GEB. I’m saying it’s more transparent, flexible, and likely cheaper. It’s your choice.

What about inflation?

Quite right — £5,000 today is worth more than £5,000 in five years after inflation is taken into account. But that’s exactly the same with a bank’s GEB. I’m only offering an alternative to their capital guaranteed product. I’m not saying that guarantee isn’t an illusion, given inflation and the time value of money – it sort of is!

Isn’t it all a bit fiddly?

Absolutely. I personally suggest new investors simply split their savings between cash and a stock market index fund, and get used to capital fluctuations as the price of higher returns.

Are you following this strategy?

Not on your nelly! Again, I think it’s better to stomach a bit of volatility in my net worth, which at the time of writing is largely in the stock market. But for people who are tempted by a guaranteed equity bond for the capital security but who rightly wonder what on earth they’re buying, the DIY GEB at least provides a simple and cheap alternative that leaves you in control.

I locked comments in the first article to keep everything in one place, so please do let me know what you think below (especially if I’ve made any maths mistakes! 😉 )

My Saturday ramble, then a list of great links.

Update: This post original began with a bit of a gender wars-style rant. I think it was fair but it didn’t really add anything, as one comment says below. I’ve deleted it.

I have mentioned before that – unlike me – most of my friends will only vote Labour.

Goodness help me that I should be stuck on an island with a bunch of Young Tories. To generalize, people who vote Labour and read The Guardian are more fun. They like better music. They eat properly. They read books. They’re not necessarily more generous to their family and friends, but they have an impulse to be more generous to ‘society’.

Alas, they are also less logical, less self-honest, and less apt to have a discussion about ideas versus feelings (especially their own).

Hari-kari

If you want an example of this at its worst, read Johann Hari’s response to the cuts in The Independent, which was forwarded to me by several of my Labour supporting chums for a response.

Hari has form. His article on Goldman Sachs and the commodity bubble earlier this year was a similar wish list of miseries that he believes the super rich are inflicting on the super poor, high on hyperbole and deficient in sense.

Hari doesn’t care that free markets have overall led to falling food prices for 50 years. True, oil has played a big role, too, but closed economies that had access to industrial fertilizers failed to benefit to the same extent as the capitalist world. China and Russia had mass starvation under the central planning and price controls that Hari longs for.

Of course, he’d say he doesn’t want centralized planning – he just doesn’t want bad things to happen.

The Haris of this world spurn the long history of human greed, war, and misery to claim we’ve deviated from some Eden that never in reality existed.

The simple fact is that to be alive now is the best it’s ever been for the common man — and better than 20 years ago, too. And that will still be the case in Britain after these cuts.

Lies, damned lies, and leftists

But I just realised I’m now going to be completely hypocritical and not address Hari’s distortions in turn. The sun is shining, and this post is late.

Besides, I’ve already ranted about one specific cut, child benefit, and once is enough for any blog in a month.

Hari and his ilk don’t listen, anyway. Resistance is fruitless.

For instance, Green Party leader Caroline Lucas was ranting on Question Time on Thursday night that the Government had gone out of its way to “hit the poor the hardest”. Evidence was immediately produced that in fact the top 2% – the richest – will be hit the hardest. She waived this fact away without an apology.

I guess “You’re hitting the richest hardest but also poor people will be poorer” just doesn’t have the same ring to it.

The simple truth is that the poor will suffer because by definition more of them are on benefits. But whether this is “the deserving poor” is a thornier matter. The Coalition seems to have gone out of its way to allocate extra money to the disabled, for instance.

Poor kids are a trickier issue. On balance money may be leaving such families, but at some point parents have to rediscover the link between fitting your life circumstances to what you can afford.

If less children were born into families that can’t afford them, more money could go to educating the rest and breaking the cycle of poverty.

Keeping it real

One example that really brought home to me the gap between supporting the ‘deserving poor’ and our benefits system was the change in housing benefit rules about age, and what’s called the Shared Room Rate.

Following the Review, it will be assumed that someone claiming this benefit should be sharing a house with others (and so entitled to less taxpayer money) up to age 35. Previously, full housing benefit kicked in at 25.

What planet are these people on? With the exception of a few Trustafarians, I don’t know anyone in London who lived alone at 25. Even the aspirant Cityboys tend to share until they buy their Clapham pad at 30. Running through two dozen friends in my head – all in work, none on benefits – only one person lives alone under 35.

Imagine this sort of unearned and disproportionate entitlement creeping throughout the system, and you begin to see why the benefits bill is so vast, and why millions of people are unemployed (yet cared for by the State) while Polish migrants with some gumption come over, find work, and show what was possible all along.

There are disabled people in this country who can’t work. There are poor children who wouldn’t have a home without State assistance. Most people could never afford to fund their health insurance 100%. And nobody wants 70-year olds sleeping under bridges. All good causes.

So I’m for a State that cares where it should care. But overall, it should care less. And the politicians who trade public money for votes, and the journalists who peddle lies and exaggerations for a living (the starkest fact – despite these cuts – is that spending is going to keep increasing for the next four years!) – can go hang.

Oh yes, I forgot that other trait: self-interest. We hear repeatedly how economic liberals are greedy and self-interested. Actually, everyone is greedy and self-interested, to some extent. Accepting that and running with it is the genius of capitalism.

For proof, just hang out in your local cafe or student union or visit some relatives or trawl the online bulletin boards to hear which spending cuts people are moaning about.

Pretty much without exception – those that affect them most.

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