Restraint will not be a saving grace

Falling income forces people to spend less and save more, including investors - although they are at the upper end of the “squeezed middle” - which perpetuates the economic doldrums.

Do you feel squeezed? If so how painful are you finding it? And is it likely to get better or worse in the foreseeable future?

It is not surprising that the compilers of the Oxford English Dictionary recently named “squeezed middle” the word of the year (even though, strictly speaking, it is not a word). It chimes with the perception that the mass of society is suffering a significant fall in its living standards with worse to come.

There is plenty of data to confirm this trend. With GDP falling 7.1% from its peak in early 2008 to its recent trough in the autumn of 2009 it is hardly surprising living standards should fall. Although GDP has risen since late 2009 it is still about 4% below its peak level of three and a half years ago. Britain seems to be finding recovery difficult.

Unsurprisingly this fall in output is translating into declining personal incomes. In 2010 real household disposable income fell for the first time in almost 30 years, according to the Office for National Statistics (ONS).

Last year’s drop of 0.8% was followed by a decline of 2.7% in the first quarter of 2011 compared with the same period in 2010. (Perspective continues below)

There are also other ways in which living standards are being squeezed, including rising unemployment, which increases insecurity for all, and more people having to take second jobs. In addition, spending cuts are likely to start to bite soon and at some point rising interest rates could hit borrowers.

Of course, when Ed Miliband, the Labour leader, uses the term “squeezed middle” it is partly for expediency. He hopes to tap into widespread resentment against what he portrays as a tiny and out-of-touch Tory elite. In retaliation Conservatives accused him of using the term in six different ways when he was interviewed on the BBC Radio 4 Today programme in November 2010.

But the often vague nature of the concept does not mean it is useless. The notion of the squeezed middle captures the reality that large swathes of British society are suffering falls in living standards. It is not simply the poorest of the poor who are experiencing squeezed incomes.

This generalised squeeze does not preclude the existence of wide social inequalities. For example, a 5% fall in income would have different implications for someone on benefits, a nurse and a millionaire. Making do with less food is not the same as postponing the purchase of a new car, let alone forsaking a second skiing holiday in St Moritz. Critics often forget that there is no necessary mathematical contradiction between relative inequalities and falling absolute incomes.

Working out the likely impact of this squeeze on retail funds and their investors is a tricky task. There are many factors involved and some trends are likely to be contradictory. For instance, it is possible that the harsh economic climate could push people to save more rather than less.

Perhaps the best place to start is to take a closer look at the demographic characteristics of fund investors. According to the Wealth and Assets Survey 2006-08 from the ONS, the latest publically available study, 10.1% of households invest in stocks and shares Isas, while 5.9% invest in unit trusts and investment trusts. Some 14.9% invest in British shares while 1.9% invest in overseas shares.

It is likely there is considerable overlap between these groups. A high proportion of those who invest directly in shares, say, are also likely to invest in funds of different types.

It is also probable, although it is not possible to be certain, that fund investors are older and wealthier than average. Typically, households build up their assets until middle age and then start drawing them down on retirement. It is also to be expected that those with more money are more likely to invest than those with lower disposable incomes.

”Making do with less food is not the same as postponing the purchase of a new car, let alone forsaking a second skiing holiday in St Moritz”

In other words it would be expected that the distribution of fund investors is skewed towards the upper end of the “squeezed middle”. They probably have a higher disposable income than average, although it is still likely to be falling as a result of the economic climate.

In itself such falling income is likely to be a strong negative for fund investment. Even those with the intention of saving more are likely to find themselves with many competing priorities. Perhaps paying more for their children to go to university or to reduce their debt levels.

Ironically, the main positive for fund investment could be the troubles in the housing market. There is little incentive for anyone to invest in housing with the market in the doldrums.

Clearly people will still need a place to live, and many will prefer to own their own homes, but fewer are likely to be tempted by residential investment.

Nor does it appear than mortgage holders are in a rush to reduce their debt. According to a study by Kate Reinold in the Bank of England Quarterly Bulletin in the second quarter of 2011: “There is little sign that, at the aggregate level, households are making an active effort to pay down debt more quickly than in the past.” On balance, those who have some spare capital could use it to invest more in funds.

Ultimately, though the key factor in a recovery in disposable income is likely to be a revival in economic growth. Although rising GDP does not automatically translate into higher living standards for all, it is the most important driving force for incomes. Until the economy recovers it is likely that all but the lucky few will feel the squeeze.

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Daniel Ben-Ami is a writer on economics and finance. His personal website can be found at www.danielbenami.com.