A sterling and gilt-edged UK Budget
There are few winners in the tightest UK Budget in a generation, but sterling and UK government bonds are among them. The fiscally conservative Budget has given a boost to both and should continue to deliver positive returns, provided the economy does not falter.
Certainly sterling has been under pressure, reaching twelve month lows against the US dollar in May, though sterling’s performance looks a lot healthier against the sickly euro. At around $1.50, sterling is still well towards the bottom end of its longer-term range against the dollar, having flirted with its lows ahead of the UK general election. We believe that it is undervalued compared to the current yield spreads and our forecasts are for appreciation against other developed currencies as investors gradually regain confidence in the UK outlook.
UK government bonds, or gilts, have not been under as much pressure as sterling. But it should be noted that the Bank of England did not make its final purchase of gilts from its £200bn quantitative easing programme until the end of January. These purchases exceeded the net issuance of new debt by the UK government over the period, despite record deficits. As a consequence, gilts have been supported, but still lagged other major sovereign bond markets ahead of the general election amid fears the UK government might lose its triple-A credit rating.
The key issue, at the heart of investor concerns, and indeed the Budget, is that of solvency: whether the UK can pay its internal and external debts without resorting to devaluation, depreciation or inflation. The question still remains, as it is part of a wider global issue over the worth of fiat currencies in the aftermath of the global financial crisis. The initial response from the new UK government has been clearly in the affirmative.
The first Budget sets out a road-map to bring both the underlying and headline deficits under control within the five-year maximum term of the current Parliament. The objective is for the level of debt to stabilise, at least as a proportion of GDP, and for the underlying, structural deficit to be eliminated.
While the Budget still leaves investors in sterling and gilts hostage to the economic cycle, we believe that its forecasts are credible and achievable. The focus on cuts is a positive, as historical data implies that spending reductions are more likely to deliver the targeted savings than tax increases are to deliver forecast revenues. Investors will also be cautious over the longevity of the coalition government, an innovation for British politics. However, having set out a clear fiscal policy, backed by a greater combined majority than that of the previous government, the survival chances of the coalition government should not be discounted. Certainly political risks in the UK do not appear higher than in the euro-zone, while the US is facing a crucial set of mid-term elections that could overturn Democratic congressional majorities.
Economic risks remain, as fiscal tightening takes demand out of the economy and is therefore an inherently deflationary process. As a consequence, the Bank of England is likely to keep interest rates low for longer. This has the side-effect of further increasing the attraction of fixed-interest gilts, as well as other fixed-income assets.
However, if growth falters, we believe that the Bank of England will have to immediately resort to quantitative easing. At this point concerns over debt deflation and stagflation are likely to trump gains from the Budget. As an example, while many euro-zone member states are currently undertaking fiscal consolidation, concerns over the economy outlook are currently weighing on the euro and the euro-zone’s more vulnerable bond markets.
Conclusion
The UK Budget will probably come to be seen as a watershed event for the UK economy, sterling and the gilt market. It materially reduces the risk that gilts get downgraded and takes pressure off sterling against the euro and dollar. The euro-zone also has plans for fiscal austerity, but faces coordination problems amongst its member states and policy action has continually lagged crises in the market. By contrast the US has not yet embarked on fiscal consolidation or faced similar market pressures as its position as a ‘safe haven’ has sidelined investor concerns.
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