Britain’s economy is still in real trouble

Until this morning, the good news had been coming thick and fast.

The FTSE 100 had risen for nine sessions in a row. That's a pretty impressive winning streak, taking it back above 4,500. Retail sales were up 1.2% in June, while the number of mortgage approvals rose again, hitting 35,235, the highest since March 2008, according to the British Bankers' Association.

But this morning's GDP figures were a real slap in the face for anyone who thought that we were nearly home and dry. Britain's economy shrunk by far more than expected.

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It seems we may take a little longer to "get back to normal" than the more optimistic pundits had thought...

British GDP shrunk by 0.8% in the second quarter of this year. That's much less grim than the 2.4% collapse in the first quarter. But it was far worse than the -0.3% average forecast. And the year-on-year fall, of 5.6%, was the worst since records began in 1955.

The recent good news is not a sign of recovery

So what about the more upbeat data we've seen recently? How does that chime with this awful GDP figure?

Well, the rise in retail sales shouldn't come as that much of a surprise. Hot weather tends to get people spending for one thing. For another, the average home owner who still has a job has seen their cost of living fall quite sharply in the past year or so. Home loan costs and rents, for that matter - have fallen. And some shops are discounting heavily.

But that can't last. Unemployment will keep rising. Home loan costs have almost certainly bottomed and look set to steadily edge higher as banks rebuild their profit margins. And crude oil might be lower than its peak last year, but at the merest sniff of recovery, it rebounds strongly. Already the price of petrol is back above £1 a litre it can't be long before the newspapers stop worrying about swine flu and start to complain about that again.

As for the continued growth in mortgage approvals, that's all very well. But plenty of deals are still falling through before they reach the completion stage. The Royal Institution of Chartered Surveyors tells The Times that 9% of agreed deals are collapsing, and that this figure has not improved in the past three months.

Peter Rollings of Marsh & Parsons tells the newspaper: "The process can take as long as seven weeks and, if it emerges that you have, say, paid a gas bill late, you go to the back of the queue again." Ray Boulger of Charcol points out that about half of applicants for 90% loan-to-value mortgages are being turned down.

So credit is still tight. It can't be emphasised enough that the easy access to cheap credit was the key driver of the housing boom. So if people can't get mortgages, current levels of house prices are simply unsustainable, unless people simply stop moving house. That seems very unlikely. As it stands, that 35,000 or so mortgage approvals is still well below levels consistent with rising prices (the monthly average over the past 12 years is more than 60,000). There's more discussion of this in our property Roundtable, published in this week's issue of MoneyWeek, out today (to get your first three issues free, click here).

Britain's revival is a long way off yet

In short, in some areas we've seen a rebound, as you'd expect, from a brutal fall in economic activity. But that's all it is a rebound, to a much lower level of activity. And in the meantime, our government and governments around the world have taken on huge amounts of debt and risk in order to bail out the financial system.

There's no such thing as a free lunch. That'll all have to be repaid somehow or at least there needs to be some semblance of a plan for reining in our national debts. Public spending will have to be hacked and slashed. Taxes may well be driven higher. And the longer it takes, the bigger the chance that something goes wrong such as interest rates on gilts being driven sharply higher by reluctant buyers.

This plus the fact that unemployment will keep ticking higher increases the chances of there being a "W-shaped" or "double dip" recession, even after we dig our way out of the current slump.

How to invest for the "slow grind back to normality"

There was an interesting column in the FT yesterday by James Barty of hedge fund, Arrowgrass Capital Partners. He argued that neither the deflationists nor the hyper-inflationists had it right. Instead, he reckons that the global economy faces a long, "slow grind back to normality".

We're not as confident as he is that we'll avoid either extreme. Governments and central banks are now so deeply entrenched in the economy that in taking extreme steps to avoid one outcome (deflation), there's more than an outside chance that they could thrust us into the other (severe inflation). That's why we reckon it's a good idea to have some exposure to gold in your portfolio as insurance for if everything else goes pear-shaped.

But for the time being, we'd agree with his view that the main thing investors should be looking for is a decent yield. With credit still tight and plenty of capacity out there, deflationary forces are likely to keep a lid on inflation for now. That means that "corporate bonds and equities with strong balance sheets and dividend yields would seem to be a sensible combination of assets for a conservative investor."

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