I say this for a simple reason. There's a significant correlation between the current account balance as a proportion of GDP and subsequent three-year returns on the All-Share index. Since 1986, this correlation has been 0.37, compared with minus 0.1 between 1966 and 1985. In recent years, big deficits have led to lower equity returns, in a way that wasn't the case in the 70s.
For example, big current account deficits - which mean big trade deficits - in the late 90s and mid-2000s led to shares falling in the following three years, while lower deficits in the early-90s and late 2000s led to better returns.
In fact, the ability of the current account balance to predict subsequent equity returns isn't much smaller than the ability of the balance to predict moves in sterling's trade-weighted index: since 1986, the correlation between the current account balance and subsequent three-year moves in sterling has been 0.42. If you think current accounts matter for sterling, then, you should also think they matter for equities.
This is a problem because the deficit is widening. It averaged over 4 per cent of GDP in the first half of this year, compared with 1.5 per cent in 2011. And with the UK growing faster than the eurozone, it's likely to widen further.
So, why do big current account deficits lead to poor returns? It's not because they lead to slower economic growth; the correlation between the current account balance and subsequent three-year real GDP growth has been zero since 1986.
Instead, one reason is that the current account is a measure of sentiment. A deficit - by definition - means that domestic capital spending exceeds domestic saving. Such excesses are associated with high optimism, because capital spending is high when companies' animal spirits are high, and savings are low when we feel we don't need to worry about putting money aside for a rainy day. High optimism, however, is quite likely to mean high optimism about equities. And from such a level, disappointments are likely.
If this is the case, perhaps we don't have much to fear. Whatever other problems the economy has now, high investment is not one of them. There's much less sign of high optimism among companies now than there was in the late 90s or mid-2000s. Instead, our deficit is a sign of weak activity among our trading partners. While this is undoubtedly a present problem, it's less obvious that it predicts bad returns over the next three years.
There is, though, a second link between the current account and equity returns. You can interpret a deficit as a sign that domestic demand exceeds domestic supply - with the gap being filled by net imports. And an excess of demand over supply is potentially inflationary. It is, therefore, no surprise that there's a negative correlation (of minus 0.35) between the current account balance and subsequent three-yearly retail price index inflation since 1986, with big deficits leading to above-average inflation. And higher inflation is bad for equities, in part because it means higher interest rates.
Perhaps, therefore, investors should be concerned by the UK's high and rising trade deficit. In this sense, we have the same worries as 50 years ago.
