We are neither surprised nor overly concerned that the UK has been downgraded and expect the other two big ratings agencies, S&P and Fitch to follow suit in the coming months. Over the past two years both France and the USA have experienced similar downgrades with no real significant consequences to either country’s ability to borrow and feel this will also be the case for the UK.
The main reason the UK has kept hold it’s ‘AAA’ rating longer than the USA is because rating agencies recognised there was a clear debt reduction programme in place. It is that same plan, which is now being called into question, with only 30% of spending cuts having taken place and a lack of growth signalling further cuts are likely to be delayed. The UK and USA have differed in their approaches to debt reduction, the former preferring to ‘grow’ their way out, with unlimited quantitative easing and the latter attempting to ‘cut’ their way out through austerity measures. Unfortunately austerity doesn’t work well in an environment with no growth – instead it raises the risks of recession.
So what does it mean for my investments?
Following the announcement by Moody’s the pound has fallen against most currencies, however that has really been a continuation of the recent weakening trend for Sterling, as markets had already been pricing in a downgrade over the past few weeks. The UK is heavily dependent on imports so a weaker pound unfortunately means higher inflation, all at a time when consumers are already struggling to reduce debt and inflation remains above target – a scenario we feel is likely to persist, even to be a tool used to erode Government debt.
Overall the rating downgrade is bad news for bonds, especially Government backed Gilts. The impact however, should be limited as the size of the budget deficit means the Government can’t afford for bond values to fall too far, as this raises future borrowing costs, which isn’t sustainable and would most likely trigger a new round of quantitative easing to support bond prices.
We feel the downgrade has actually come at a good time, as it is more likely to force the Chancellor’s hand in the upcoming budget, into implementing growth orientated policies, an approach that has worked well in the US. This should provide continued support for capital markets and infrastructure companies may stand to benefit if investment in longer term projects increases. Lower interest rates are also likely to remain in the UK in a low growth environment, so good news for those with mortgages but less so for savers or those looking at buying an annuity.
The recent announcement is a stark reminder why UK investors should not have a bias in their portfolio to the domestic economy. With a budget deficit ratio to GDP that is worse than Portugal and only slightly better than that of Greece it is no wonder that the UK has lost its ‘AAA’ rating and our clients can take comfort from the asset allocation of our portfolios which are underweight bonds, and which will continue. Furthermore within the bond sector we have a higher weighting to global bonds. We are also underweight UK Equities and continue with our global equity bias.