Opinion

4 principles to remember in the age of austerity

By Matthew Lynn (China Daily)
Updated: 2010-07-28 09:50

One thing has become clear during the sovereign-debt crisis: Governments everywhere are going to be cutting their spending savagely over the next five years.

They may do it under the direction of the International Monetary Fund, like Greece. Or voluntarily, like the United Kingdom and Germany. Or slowly and reluctantly, like the US. One way or another, it has to happen. You can't run deficits of 10 percent of gross domestic product or more forever.

But what does that mean for investors?

The UK stock market has already priced in earnings shocks from companies that have run into trouble because of reduced government spending. And, in most developed countries, the cuts are only just starting. We'll see a lot of corporate-profit declines across Europe and the US in the next couple of years.

To survive that you need to short companies that depend on government spending; think about the regions that will avoid the worst of the pain; and focus on businesses that can save the government some money. Follow those simple rules, and your portfolio should make it through the years of belt-tightening.

There is already plenty of evidence from the UK about the impact that the austerity drive can have on share prices. Cable & Wireless Worldwide Plc, the telecommunications provider, said last week that spending cuts by David Cameron's new coalition government would lower earnings. Its shares dropped 17 percent on the day. Last month, Connaught Plc, which maintains social housing, told shareholders the same message. Its shares dropped as much as 41 percent on the day.

It's no great surprise that austerity drives will hit a lot of companies hard. State spending accounts for 30 percent to 50 percent of the economy, depending on which country you look at. Start hacking away at half of your GDP, and a lot of people will find life much tougher.

So how should you steer your portfolio through the age of austerity? Here are four principles to keep in mind:

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One: Keep away from government contractors. In the last decade, the state has outsourced a lot of its work. There have been big contracts awarded - and, as we know, governments are very bad at getting value for money, so most of those contracts came with fat profit margins. Likewise, defense companies will do it tough - wars are a real luxury when you need to cut public spending by a quarter. You don't want to be holding shares in companies such as defense manufacturer BAE Systems Plc in that kind of environment. All of them are going to suffer. Clear them out of your portfolio - then short them.

Two: Focus on regions. Government spending is always concentrated in particular areas, either because they are poor, or because it is where the governing party's voters happen to live. In the UK, that is Scotland, Wales and the north of England, the heartland of the Labour Party, which held power for the last 13 years. But every country has a region of high public spending. Avoid them, because they will be hit hardest. But other places such as prosperous London and the southeast of the country will do fine. Invest in businesses that focus on those places and you won't regret it.

In the UK, take a look at Ocado Group Plc. The online grocery retailer got a rough ride in its initial public offering last week. Yet the wealthy shoppers of the south-east of England who make up its core market are going to get through the austerity drive better than most people.