UK credit downgrade – market reactions

27th February 2013

The credit downgrade has prompted a stream of commentary though most commentators are emphasising that it probably does not have huge implications for investors at least not in the short term. Mindful Money brings you a selection below

Arguably, the most thought-provoking is from Simon Ward, Henderson chief economist. He suggests that either the UK should keep its triple A rating or be downgraded to junk status.

Either the UK should have kept its AAA or the premise of the rating needs to change

Simon Ward, chief economist, Henderson Global Investors

“The credit rating of a security is intended to reflect the risk that an investor will suffer a nominal loss of interest or principal. This risk is infinitesimal for a security issued in domestic currency by a sovereign nation with its own central bank. Such securities should carry a AAA rating regardless of economic and fiscal trends.

“The exercise of rating sovereign domestic-currency debt would be meaningful if the intention, instead, were to measure the risk of an investor suffering a loss of purchasing power, i.e. an investment return below inflation. Economic and fiscal trends, among other factors, would then be relevant for assessing the probability of monetary policy allowing excessive money supply expansion, resulting in high inflation.

“If, under such an alternative approach, “investment-grade” were defined as meaning a high probability that the initial yield on a security would more than compensate for future inflation, few major countries would currently qualify. The UK would be among the junkier credits, reflecting its poor inflation record and the lack of institutional constraints on a policy-making elite with a strong bias towards currency depreciation.

“The credit rating of gilts, in other words, should be AAA on the agencies’ definition or sub-investment-grade (B?) based on prospective purchasing power – but certainly not AA.”

Sterling is losing its safe haven status – only the dollar remains

Robert Farago, Head of Asset Allocation at Schroders Private Banking 

“Investors in the UK shouldn’t be unduly dismayed by the Moody’s downgrade. There is very little to disagree with in Moody’s analysis of the economic outlook for the UK, but also no reason why a change in credit rating should have a sustained impact on UK equities or bonds. Outside the confines of the euro, there is no sign that markets are demanding a higher yield from countries with higher levels of debt – although there is no guarantee that this will remain the case, since the path to a sustainable government finances remains a treacherous one.

“That’s not to say UK investors have nothing to worry about. There are serious questions about whether the UK will be able to generate sufficient growth to start paying down its debt. Inflation is also a concern – unless growth picks up, the UK could find itself in a stagflationary environment in three or four years down the line.

“Sterling is also in the process of losing its safe haven status, due to a combination of the euro crisis easing and conditions in the UK proving more challenging. Looked at against the US dollar, the currency appears fair value. However, the dollar stands out as the one obvious currency to maintain its safe haven status.”

Other agencies will probably follow suit

Johan Jooste, Chief Market Strategist at Merrill Lynch Wealth Management EMEA

“While presenting an encumbrance for the Government to deal with, we do not view the underlying reasons for the downgrade as unreasonable or for that matter terribly surprising. It is an open question whether or not the Government would have been able to avoid this outcome under any circumstance. Avoiding austerity might have pushed the debt numbers further into the red without necessarily stimulating growth any more than monetary policy has succeeded in doing thus far. Quite likely, the U.K.’s economic and debt trajectory post crisis made this development more or less inevitable. As such, and analogous to the downgrade suffered by the U.S. last year, this is a reflection of economic conditions and not necessarily an increase in default probability for the U.K.

“To underscore this view, the initial response from the UK gilt market has been very similar to that of the French market after that country’s downgrade – virtually no reaction. While U.S. bonds actually rallied after suffering a downgrade, this is less likely in the U.K. now as the safe-haven status of U.S. Treasuries at the time was perhaps a bigger driver than reaction to the rating. From here there is a good chance that the remaining agencies will follow suit and downgrade the U.K”.

Tight corner for Chancellor but Gilt investors should be more worried about the inflation risk

Tom Elliott, Global Markets Strategist at J.P. Morgan Asset Management  

“It is probably only a question of time before other rating agencies follow Moody’s. Furthermore, with the eurozone debt crisis weighing less on investor’s minds than it has for some years now, and signs of accelerating growth in emerging markets and a recovery in the US, the need for safe haven assets such as Gilts and sterling has been reduced.

“This puts UK chancellor George Osborne in a tight corner – both politically, because he has attached much weight to the UK maintaining its triple A rating, and economically, because it is not clear that austerity is actually working as a deficit reduction tool.

“Critics of the austerity policy suggest that a boost to growth could come from reducing the deficit at a slower rate than planned, either by reversing some recent tax hikes, or by delaying cuts in public spending. But this is not a guaranteed outcome.

“The Keynesian approach of boosting aggregate demand through deficit spending was never intended, by Keynes, to apply to already highly indebted economies. It was meant to temporarily boost demand until a recovery was self-sustaining. The longer, and larger, that budget deficits persist, the higher the risk that they replace genuine demand growth rather than stimulate it.

“Therefore, investors may be unwilling to continue to lend to the UK at what are still historically low interest rates, if Osborne is seen to take a more relaxed attitude towards debt reduction. Any rise in interest rates means still more money has to be borrowed to service the existing debt.

“Furthermore, some economists argue, on the basis of historical evidence from around the world,  that when the debt-to-GDP level exceeds 90 per cent it becomes unsustainable, with deliberate inflation or outright default often following.

“But to holders of Gilts what matters most is perhaps not the politics or the growth arguments, but the risk that inflation destroys the real value of their investments. Particularly given the Bank of England’s relaxed stance on inflation in light of weak growth.”

 

Surprise at the decision because things are actually getting better

Ian Winship, Head of Sterling Bonds BlackRock

“The timing of this decision is surprising for several reasons. In terms of the Economic story we would seem to be past the worst and believe it very unlikely that a factor such as the collapse in construction activity that weighed on GDP in 2012 will reoccur.  Risk sentiment is currently strong, risk-free rates remain low, bank funding costs have fallen and are backstopped by the FLS. As a result, credit availability is improving and the price of that credit (mortgage rates) is falling.

“The referenced medium-term growth outlook, which was downgraded by the market last year and by the OBR in December’s Autumn Statement, has if anything improved since then. In fact, the current set of financial conditions in the UK – yields below 50bps out to mid 2016, bank funding costs sharply down, currency weakening – put the economy in the best situation for a recovery that we have seen since the crisis.

“The deficit has also benefitted from several one-off factors over the last 12 months (Royal Mail pension assets, Bank of England QE coupons and profits from its SLS scheme, the 4G spectrum auction) which have significantly reduced the near-term need to raise money in the gilt market.

“However, we agree that the “the shock-absorption capacity of the government’s balance sheet” has deteriorated. This has been clear since the Eurozone crisis in 2011 shifted the fiscal consolidation off-track but this is not “new” news. The government has no way of offsetting an exogenous shock it’s consolidation plan is fully conditional on a slow path to recovery.

“The likely impact of the downgrade will be political, with implications for the shape of the Chancellor’s March budget and the outlook for the deficit, and in the longer term the extent to which the Moody’s action may influence thinking on matters as diverse as the General Election itself in 2015 and the EU referendum. The currency may continue to bear the brunt of political uncertainties and this at some point will have more of a real economic impact.”

More of a political than an economic event. Government emphasis on Aaa “inappropriate”

Toby Nangle, Head of Multi Asset Threadneedle Investments

“On Friday Moody’s Investor Service cut the rating on the United Kingdom from Aaa to Aa1 – the first cut to the rating in the country’s history. The downgrade is a market event only insofar as it has political ramifications. The Government put undue and inappropriate emphasis on the defence of the Aaa rating, and for this reason has suffered a hit to its political credibility. The Government has repeatedly described the UK’s finances as being analogous to those of a private household, with very low Gilt yields reflecting market perceptions of its creditworthiness. The Government has favourably contrasted these low government bond yields with high yields in a number of Eurozone countries that are as fiscally troubled as the UK. But this comparison is without base and is disingenuous.

“The United Kingdom is a monetary sovereign, and its government bond yields overwhelmingly reflect the expected path of future Bank of England policy rates. Yields are low because the market believes that rates will remain low, and because of the Bank of England’s policy of quantitative easing. By contrast, Eurozone sovereign borrowing costs depend on not only the expected course of ECB policy rates, but also market perceptions of creditworthiness, and so fiscally troubled sovereign yields are correspondingly varied. The Government’s frequent comparison between Eurozone countries and the UK borrowing costs has served principally to explain to the public the benefits of pursuing a policy of fiscal restraint.

“This is not to deny the large structural deficit that the UK has in place, nor that the main aim of the Treasury should be to eradicate this structural deficit. Economists and political parties of all colours agree on this point.

“The spectre of a rating downgrade taking the UK on a path towards a Greece-like ‘market hell’ is not relevant. If anything, the UK’s worst case scenario would be to suffer a crisis more analogous to Iceland’s – where ratings downgrades coincided with a precipitous collapse in the currency, the financial system, and domestic and international confidence – but we are a long way from such a scenario playing out.”

Sterling receives a nudge not a kicking

Chris Towner, Director, FX Advisory Services, at foreign currency exchange brokers HiFX:

“Sterling could have been a lot worse off if it had not have been for the following reasons. Firstly Sterling had already weakened aggressively in anticipation of this move and therefore this news was pretty much priced in to Sterling.

“Secondly, unlike the downgrades of the US and France which left these countries on negative watch, the UK has been put on a ‘stable outlook’ which means another cut in the rating is not anticipated over the next 12-18 months. This has perhaps helped ease the negativity towards Sterling.

“Therefore unlike shocking news which often creates high levels of volatility in the market, GBP/USD has been trading every pip and it is the calmest we have seen it for a while allowing for the fact that we saw it gap a cent lower after the initial shock.

“What next from here? Sterling is wounded and the UK’s reputation as a safe haven has been tarnished. The predators in the market will now be looking at Sterling to see whether there is any more opportunity for weakness; however, given that it is already significantly weaker, there may now be some other more opportunistic trades in the market leaving Sterling to lick its wounds. George Osborne on the other hand has another theatre of predators to face!”

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