By Mark Holman
After the markets closed last Friday, Moody’s became the first rating agency to take the overdue plunge and strip the UK of its coveted AAA rating. Part of the rationale for Moody’s action was its projection that the UK’s total debt to GDP would reach 96% by 2016, by which point the current government could be out of office. Having said that, the rating agency further commented that one of the attributes of the most highly rated sovereigns is their ability and commitment to bring down their debt burdens when they become large, and for this reason they have the new UK Aa1 rating assessed as stable. Both Fitch and S&P already have a negative outlook on their AAA ratings, so further downgrades must be viewed as likely.
From our perspective a downgrade was inevitable. The UK’s debt burden has been consistently increasing despite pledges from the Chancellor to stem the rise. The government was faced with a difficult choice: austerity to reduce debt or spend/invest further to create growth to improve the debt to GDP metric. In the end the Chancellor was caught in the middle, having not made severe enough cost cuts to reduce debt, but those that were made have been a drag on growth. After two years of flat growth we now still stand with GDP more than 3% lower than the pre-crisis peak, but with debt having almost doubled.
Typically when a creditor’s rating deteriorates they end up paying more for their debt. However for sovereigns that is not always the case as they have control of monetary policy, and as for the UK, they have control of their central bank, and their own currency. Pre-crisis, 10-year gilt yields were c5%; they are now just over 2%. As the credit quality of the UK has gradually deteriorated over this period, it is therefore not the main factor driving yields. The market is clearly saying that despite this deterioration, the credit quality is still unquestioned.
While this is still the case we would expect the market to effectively ignore this downgrade, and potential further downgrades. Even if yields were to move higher as a consequence it would have less of an impact to the UK than most other sovereigns as the average maturity of our debt burden is around 15 years, which is significantly longer than most other nations, meaning that less debt needs to be refinanced and re-priced every year.
While the downgrade story is likely to dominate the financial press and commons debate, it is the reaction of the Bank of England that we will be paying most attention to. The minutes from the last MPC meeting released last week showed that an unexpected three of the nine members (including Mr King) favoured a return to QE. 10-year gilt yields have been rising steadily recently and are now around 70bps higher than the lows seen in August last year, so a return of the market’s biggest buyer may underpin any further slide in prices.
So while market reaction is likely to be uneventful, the government cannot relax in its debt reduction strategy because as soon as it takes the market reaction for granted the “unquestioned credit quality” may well be tested, and we can see from what has happened across the eurozone periphery what can happen when this occurs. However, for now the rating adjustment is merely symbolic and helpful for the opposition to gain some political capital.
Mark Holman is a managing partner at TwentyFour Asset Management
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