Focus on the UK downgrade
That there has been a downgrade didn’t come as a surprise given the metrics used to determine ratings and the approaches adopted by rating agencies, but it’s a nonsense that the UK couldn’t or wouldn’t service and repay its debts given that it can tax to pay as required. What’s more, the UK has an average maturity of debt of 14.5 years (so double the maturity of public debt in both Europe and the US), and only 25% of UK gilts are index linked so the UK can inflate away its debts, helped as required by Quantitative Easing (QE). In addition, the UK has net foreign debt of 14% of GDP, so the UK can devalue the pound to support growth and inflation without worrying that net external debt would rise to unsustainable levels.
In terms of the budget position, the primary budget deficit is high, at 5.6% of GDP (in 2012, on IMF estimates), but to put this in context, the US and Japan are higher, at 6.5% and 9.0% of GDP respectively. On IMF data, the gross government debt to GDP ratio is below that of the US and Japan (89% of GDP, compared to 107% of GDP and 237% of GDP). It’s worth noting that the UK was put on a stable outlook after the downgrade – although we should expect other agencies to follow Moody’s with downgrades.
As to what market reaction to expect, when France, Japan and US were downgraded, there was little perceptible impact on the currency or the bond markets, and Japan is four notches below triple A and yet has a bond yield of 0.7%. Also for the UK, if gilts were to fall precipitously, the Bank of England’s Monetary Policy Committee (BoE’s MPC) could re-start QE, and three of the nine members of the MPC (including the Governor) talked about re-starting QE at their latest meeting and the BoE already owns c40% of the gilt market.
Whilst gilts should be relatively safe, inflation expectations will be on the up, and therefore the pound will likely continue to head lower, although it’s hardly ‘cheap’ given that its trade-weighted index is only 2% below its post-2008 average. Apart from the prospect of rising inflation worries, fund flows are adverse with the UK having a near-record current account deficit of 4% of GDP, the BoE is dovish relative to other major central banks, and growth remains poor, being some 3.3% below its previous peak whilst UK household leverage is much higher with less de-leveraging to date, than the US.
Against the backcloth, the UK equity market can rally further. Some nine out of ten sectors are cheap versus their global peer group and if sterling does weaken further, this is positive for UK equities in local currency terms, given that 80% of earnings come from overseas. The one issue is what exactly happens to inflation, in that a modest rise in inflation expectations can be construed as good for equities, which are an inflation hedge until inflation gets to 4%-5%, and as a technical factor if inflation rises or is expected to rise, leading to higher bond yields, pension funds may turn buyers of equities once more, with the irony that for the first time in nearly fifty years, pension fund weightings to bonds presently exceed their weightings to equities.
The policy environment is of course important and we can reasonably assume that the BoE’s agenda will be clearly focused on boosting growth, with commentators highlighting the possibilities of expansion of the funding for lending scheme, help for housing, easing of bank regulations, and the introduction of funding for infrastructure, with only limited fiscal flexibility in any case but exacerbated by the spotlight created by the downgrade.
For investors, a good case for quality UK risk assets remains, particularly overseas earner equities and domestic reflation beneficiaries such as real estate and domestic banks.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla