Prepare yourself for when Britain’s safe haven appeal wears off

It may seem a bit mad to those of us living here, but Britain has a lot of appeal as a safe haven.

We have a political and legal system with one of the best track records in the world in terms of longevity and stability. And despite our never-ending breast beating about decline, we are still one of the world's biggest economies. As for sterling it might not be the global reserve currency any more, but it's unlikely to cease to exist in the near future.

So if you're a wealthy foreigner living in a risky part of the world, and you want to put your money somewhere safer, then Britain is very appealing. Your money is unlikely to get trapped there by capital controls. You don't have to bribe anyone. And anything you buy from property to equities to bonds is protected by a proven, functional legal system.

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The big question is: what happens when everyone stops looking for a safe haven?

The secret to Britain's success stories foreign money

The fuel behind the brightest spots in the British economy in recent years can be summed up in two words: foreign money.

Take house prices. If you live outside London, you could be forgiven for imagining that the entire capital is shielded by some sort of crash-proof moat.

The way the papers sometimes paint it, London is a dynamic global playground that services the world's wealthy elite, and thoughtfully allows some of those earnings to trickle down to the parasitic appendage that is the rest of the UK.

There's a grain of truth to all this. But only a grain. In fact, it's a very small portion of London that's benefited from the flood of foreign money. According to property research group Hometrack, house prices are lower than they were in 2007 in more than half of London postcodes.

Average prices are down 20% across 193 of the capital's 243 postcodes, says the FT. A further ten are flat on 2007 in other words, they're back at peak prices. The remaining 40 capped by super-wealthy bits like Knightsbridge and Belgravia have risen beyond the 2007 peak.

The parts of London that have risen have either been fuelled directly by demand from foreign buyers, or by knock-on demand from wealthy British people who have been pushed out of their traditional haunts by even wealthier overseas buyers.

Anything fuelled primarily by demand from domestic money has fallen in price, just as is the case in the rest of the country.

British buyers are being ground down

This shouldn't come as any surprise. If you live in Britain and earn your wages here, then chances are your standard of living has been squeezed hard in the last few years.

Price inflation has been above wage inflation since the 2008 slump. At first, the impact of the crash was offset by the plunge in interest rates (not to mention the plunge in oil prices). If you kept hold of your job, and you had a variable-rate home loan, chances are you felt a lot richer.

But since 2009, those gains have been gradually rolled back. Your wages have failed to keep up with the cost of living. And Bank of England money printing has hammered sterling, ensuring in the process that any benefit from falling commodity prices was very short-lived.

So it's little wonder that what demand exists in the economy is primarily being driven by overseas money.

The danger is that this money dries up or finds somewhere better to go.

It's not as far-fetched as it might sound. The luxury sector has been one of the few success stories on the high street. But with China certainly slowing down (even if the financial industry refuses to acknowledge it), demand in that area is very likely to falter.

And on the other hand, if Europeans become even a little more confident that the euro will survive, those safe haven flows could dry up too. After all, the eurozone crisis has been obvious for a long time. If I wanted to get my money out of there, I'd have moved most of it by now. Alternatively, capital controls in the region will make it harder for money to get out. Either way, there's only so much fleeing capital to go around.

Avoid gilts and be wary of sterling

I've already suggested that I'd avoid the luxury goods sector. I also think you should avoid gilts. We've been saying this for a while (with the honourable exception of James Ferguson), and it's fair to point out that they've done very well in recent years. But I don't see the point in investing in an over-priced asset on the basis that it might become even more over-priced.

Yes, the major counterpoint to anyone suggesting that government debt is in a bubble, is to point to Japan. Betting against Japanese government bonds (JGBs) has been a losing battle for years.

However, there are some key differences between Japan and the UK (or the US, for that matter). There's the obvious one the fact that the vast majority of JGBs are owned by domestic investors, who tend to be less fickle in their appetites.

But there's also the fact that Japan doesn't suffer from inflation. It suffers from deflation. So Japan's government bonds actually offer investors a real return, even at very low nominal yields.

You can't say that for gilts. Indeed, at current levels, it's costing you around 2.5% in real terms to lend the British government money over ten years. Even if inflation falls as far as Mervyn King hopes it will this year, you'll still not be getting paid anything to lend to Britain's politicians.

So I wouldn't touch gilts with a ten-foot bargepole. I wouldn't short them either: the Bank of England can keep yields propped up by printing money and it probably will. But this could have another nasty knock-on effect: a weaker pound.

Sterling had a pretty good year last year, mainly because it didn't look that bad a bet compared to most other currencies. But I suspect that against a backdrop of weak growth combined with rampant quantitative easing, that could change this year. We like gold anyway but if you're a British investor, you should make doubly sure you have some in your portfolio to protect against a weaker currency.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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