Where to invest as the government flounders

It's all going horribly wrong for George Osborne, Britain's chancellor.

The country's public finances deteriorated in July. Corporation tax receipts fell off a cliff.

Public sector borrowing is now £9.3bn higher so far this year than at the same time last year. Worse, the government actually added to its debt in July, a month when economists had expected it to be £2.2bn in the black.

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Labour has been quick to jump on the numbers calling them a "damning indictment" of the government's austerity strategy. And many members of the coalition are none too happy either. Lib Dem MP John Pugh concedes the government's strategy has been "blown off course". Blown out of the water some would say.

So are the latest numbers as bad as they look for Britain? And as an investor, how can you protect yourself?

Austerity, what austerity?

According to the Labour party and sections of the media, the government's austerity policies are doing immense damage to the economy.

But is that really true? The austerity measures do mean that jobs are being lost in the public sector. And that reduces the spending power of those unemployed workers.

However, government spending continues to go up. So its actions are actually boosting GDP right now.If you believe in GDP as a measure of economic prosperity, that's good news sort of.

The latest figures show that government spending is up 3.5% year-to-date. The problem is that money coming in is barely growing at all - up 1.1%. The end result is that government borrowing is up 26.2% so far this year (excluding the transfer of Royal Mail pension fund assets).

That's very different from the official forecast.The Office of Budget Responsibility (OBR) said that the budget deficit (the difference between income and expenditure) would come down this year, not go up.

So what's going wrong?

Two reasons that the deficit isn't getting smaller

Here's the nub of the problem - the government's deficit reduction plan has relied on one key thing: the economy growing.

The OBR still officially thinks that the UK economy will be growing at a rate of 3% in two to three years. It's betting that tax receipts will go up and will shrink the deficit.

But there's a big problem here. A lot of GDP in the boom years relied on excess credit.With that credit now taken away, plus the burden of debt to pay off, how exactly is the economy going to grow as fast as the OBR thinks it will?

The answer is simple it won't. The latest numbers are very worrying. Corporation tax receipts fell by 20%, mainly due to a very weak oil and gas sector. This doesn't look like improving any time soon. Expect the next couple of quarters' corporation tax receipts to be weak too.

The OBR may think that government receipts will go up by 3.9% this year and by over 5% next. But this just looks fanciful.

Not only this, but the government simply isn't tackling the bloated size of the state.Government spending is growing, and is expected to be higher in four years' time than it is today.

And for investors there's another worry the bond market.

The bond market seems too relaxed

We may now have to face up to the possibility that the deficit may not actually come down at all. It could actually get worse. Government debt could get seriously out of control.

Does the bond market care? It doesn't seem to. Yields on ten-year bonds have hardly moved. The UK government can still borrow for ten years at 1.7%.

This seems crazy. The government's finances are in a perilous state. If the deficit expands rather than shrinks, then the size of money printing needed to plug the gap will be bigger than most of us currently think. If this happens, don't expect the pound to react favourably.

The risk of higher bond yields and the damaging knock-on effect on most financial assets has been with us for a long time. Too many people think that the Bank of England can stop a day of reckoning by firing up its QE printing press. We doubt whether it can keep doing this.

Unless the government can get a grip on its debt then something will have to give. Either commercial bond investors will start asking for higher interest rates to keep on lending to us, or the value of the pound will go down to reflect the increases in the money supply. It's possible that both scenarios could come to pass.

So where should you invest now?

If the scenario of rising interest rates and falling exchange rates worries you, then it makes sense to own assets in another currency that can appreciate against the pound.

Norway looks like a good bet. It has a strong economy with a healthy trade surplus. Its government finances look to be in impeccable shape with a budget surplus amounting to 15% of GDP expected this year. George Osborne eat your heart out.

A possible dark cloud is its property market, which looks rather frothy at the moment. But this could still be good news for anyone wanting to invest in the Norwegian krone. Interest rates might have to rise to cool the property market which could make the krone more attractive to investors. One word of warning though, the krone is a petro-currency and will be quite closely related to changes in the oil price.

Sadly, it's not that easy to invest directly in Norway there are restrictions on foreigners opening bank accounts for example.

However, two good options include buying shares in Norwegian companies such as Statoil (STL:OSL) if you think the oil price will hold up and buying a currency exchange-traded fund(ETF) such as ETFS Foreign Exchange Ltd, Long NOK, Short GBP (LSE:GBNO) as a hedge against a weakening pound.

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

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