Planning pays off – Budget thoughts for this year and beyond

Cost & Economic Headwinds

In the past I have written about our annual budget plan. All running fine and Covid aside (ie lower spend) as expected. But the world headwinds have increased from a gentle breeze to an ever strengthening wind and may well end up a storm at some point this year.

For those remembering the early 1970s, I suspect we are in for some of that. I remember as a small boy growing up in Yorkshire a very cold winter. Our house had oil-based heating and suddenly, we had no oil and dad could not afford to buy any as a result of the massive oil price hike. The rapid inflation caused interest rates to rise and people could not afford mortgages or the rent. Food prices shot up and energy got so constrained that the lights went out for 3 days a week.

Sound familiar ?

Well, we are not there yet, and there are lots of things very different. For example, we are a lot more connected. Electricity is an essential aspect of life and few jobs can really exist without it. Pretty much the supply chain of all goods requires electricity (to run the computers). In the 1970’s it was all paper. Telephones worked as they were hard wired.

Any prolonged power outage would be little short of catastrophic. I mean … we could not run our home heating (need electricity), cooking (needs electricity), fridge, freezer etc etc.Then mobiles would go out as no charge.

Very quickly we would be in a full national emergency. Personally, I would say 3 or 4 days tops.

In Scotland there was a recent set of 3 big Atlantic storms. Power lines taken out and we all had (if paying attention) a small inkling of what lacking power for 7-10 days would look like. But the difference is that it affected a relatively small set of areas, relatively few people and there were support services around, they got helped and sorted.

Now a huge grid outage, the inability to generate sufficient power and we would end up (like in South Africa) with load shedding. All of which, has a huge economic knock on effect.

All doom & gloom ?

Well no. The likelihood of this is still not high. We are heading into warmer summer and less power is needed. Oil pricing has (arguably as I write) peaked and indeed output was already planned to be increased. As I understand it world oil output was due to be almost 10% higher in a year.

The Ukraine crisis is the bit that will have the biggest long term effect and that is in constrained supplies, reduced core foods (like wheat & grain), reduced fertilisers (which will knock on to food production).

Whilst energy costs are likely near the peak for now, food and commodity costs will rocket. The knock on inflationary effect will cause at least some fiscal change. The days of just printing money (ie Quantitative Easing) are all but over. Inflation effects cannot be fixed by increasing the money supply. That is like pouring petrol on a fire. Good old fashioned tightening measures of budget cutting, increasing interest rates and taxation will be used. They are, after all, the only real way of dampening down a wildly overheating inflation spiral.

Is that not doom ridden I can hear ?

Well … depends how you look at it.

At a human and societal level it is terrible. Ordinary people and most at the ‘bottom’ of the income scale really suffer. But for those of us in investing, there are big opportunities given time and patience.

I am not quite yet at the point of being able to hold a lot of cash – I really have a lot tied up and need a few things to happen soon so I can sell down. But a market is, I fear, correction really is coming. I say ‘fear’, but it is inevitable and to suggest as Gordon Brown once said that the ‘bust’ part of ‘boom & bust’ was over was utterly naive.

Anyone not seeing this as a high probability within a year is really not paying attention. With less spending, commerce goes down. With commerce going down, tax take reduces meaning either lower spending or higher borrowing, but without economic growth to pay it off it spirals very fast.

Total economic output drops. Therefore, companies that are largely valued on forward cash-flow predictive models get ‘re-rated’.

Recessions reduce stock markets !

Markets make money on the way up … and down ! When steam slows down and economies start to trade laterally, well, what a surprise, the markets drop at a handy point to keep the profits rolling in (for some !). Or am I just being a bit of a cynic ?

Anyway, at a just plain logical level, it is impossible to reduce consumption across pretty much everything and not have a stock market deep impact event. Our economies grow primarily by virtue of spending and the transactions that brings. Just look at the mini Covid crash of 2020. Some companies lost 40%, but over a few months had pretty much recovered.

This time, we would probably see a deeper and longer dip. Those who hold cash get the opportunity to buy at the bottom. In almost all recoveries, when the green shoots start, they grow very rapidly for a few months and then slow. The opportunity to make 30, 40, 50% in a few months is very high for those with the floating cash and confidence to see through the noise.

I guess it will remain to be seen if I have that and the bottle for it !

One other benefit is that prices almost always drop as a result of deep correction. So purchase power goes up. This is particularly true in the fairly overheated property market.

Taking a look at our current budget plan

Without going over the gory details, as things stand around 58% of our current spend goes on bills, mortgage and relatively fixed things, 16% on various miscellaneous items and 27% on what can loosely be described as ‘fun’: holidays, restaurants, weekends away etc. If I exclude our mortgage we save £10k in the year and the relative percentages equate to around half on bills/fixed, about a fifth on miscellaneous items and the rest on ‘fun.

The energy price hike we are seeing now are massive. We pay a fixed £118 pcm, but in August that ends. I expect this to move to £280-£300 pcm unless there is a significant change in raw energy costs. This basically will add around  £2,000 to the year (on a full year basis) and increases in car fuel, food etc around another £1,000 (and maybe a bit more if food inflation really bites hard.

So I am on fairly safe money to estimate this. So whilst I expect our spend this year overall not to change, our costs will rise by probably £3k+.

Two years ago I looked at what happened in 2019 plans and reflected on what I could flex down if needed. Then, I came to the conclusion that if we (as turned out during covid) radically reduced spending, I could knock a third off total spend by not going on holiday, living more frugally and just having the odd pint down the pub. The weird thing is that during Covid, much of this happened and whilst a testing time, we certainly live in a lovely village, with plenty of open space and walks. We had it easy compared to many for which we feel very fortunate.

But in terms of budget, I could knock £10k off and not have a massive impact on our day to day lives. Yes it would mean little or no travel, only the occasional meal out, probably not going to watch the rugby in the pub but at home with a glass of wine or bottle of beer, more coffee & cake in the garden. All of this was lockdown and whilst still having some spend and freedom, if we have to do this, then not the end of the world.

Absorbing a cost increase of £3k is not going to be hard, but it is always useful to visualise the impact of costs. In context, an extra £3k of costs means one less week away in the sun in the Canary Islands !!

This is why it is so important to have a forward plan and know what you can and cannot easily flex. We have zero stress over this. Just change the balance of bills to fun ! Life changes after all.

Any lessons in this ?

It is often said that all financial lessons can only be learned by personal pain. No amount of ‘reading in a book’ can either mentally prepare you or give you the insight needed to make a ‘best’ choice. I have learned a number of things in the past 5 years. But one decision I made does rankle a bit now …. lesson now learned !

It would definitely be better right now if we had lower outgoings.

In real terms today, our 2022 budget is circa £47k. If I had payed off the Mortgage it would be £37k. My wife has a work pension she took early that is around £7k, so we would need circa £30k instead of £40k (reducing no spend at all). That is 25% less income needed.

Taking essentially 25% off our required income would be very handy. And yes  3 years ago chose not to pay off our mortgage when I had more than enough free cash at the time to do so. It would have taken at the time about £70k. I reflected that the £70k I could better employed in growth and to a degree that has happened at least initially, but since then we had a reasonable correction and have rather more significant market headwinds. Not to mention the 2 years lost to Covid, so now not such a smart move.

The thing I did not consider was the emotional impact when faced as we are now with cost of living pressure and far too much really just tied up.

If I had payed off the mortgage then our required monthly income would be around approx  £10k less in the year.

That is a lot of options !

Safe Withdrawal Rates

There are those devotee’s of the so called ‘4% rule’ and Safe Withdrawal Rates (SWR). In the UK, returns are historically lower than the USA and a more realistic SWR is in the range 3.0-3.3%. This essentially means I need a fund of knocking £330k+ to generate £10k. In reality of course I only need around £40k (the amount left on the mortgage), but the key point is that if you have a debt, you do need to consider ‘what is it that I need to cover that debt ?

Leverage is often used in the investing world, and increasingly by ‘sophisticated’ or higher net worth individuals. But it carries risk and that risk is magnified exponentially as markets contract and costs rise. My assessment of the relative risk was that investing in growth was a low risk path that would deliver me an overall greater wealth. Whilst a correction and general value reduction is always a possibility, what I did not do was re-assess and bail soon enough to reduce the debt and income need.

Biggest lesson here, is clear your debts as fast as possible.

The long term net worth may be lower, but then the reduction in personal risk when markets are under stress will be exponentially lower … as will your stress level.

In retrospect, I did all the right things except one. I looked forward, I worked out what can be flexed, I looked at growth potential and the relative value of a tiny interest rate with respect to that. I could clearly see long term cash flows and had them planned.

But what I did not do, is objectively plan to review this regularly and ask myself whether the risk profile had changed. In retrospect, even 18 months ago, after the initial covid correction, selling assets and clearing the remaining mortgage would have been a good option reducing my relative risks and reducing my income needs.

But I didn’t do that ….. all financial lessons are learned the hard way !!

 

Keep your risks, targets and forward cash flow plans under regular review !

Keep fighting you plucky and brave Ukrainians

 

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