Not so sterling

Investment Notes

All three of the major credit rating agencies, Standard & Poor’s, Moody’s and Fitch, have the UK rated at AAA but with a negative outlook. A fourth, Dagong, a Chinese-owned rating agency, already has the UK at only A+, four notches below AAA. They have each warned that a failure to reach the government’s deficit reduction targets in 2013, may lead to a decision to remove the AAA designation. The worse than expected growth of the UK economy over the last two years has produced less tax revenue than expected and meant that reducing government spending has proved more difficult to achieve. The government looks increasingly unlikely to meet its deficit targets, and the chances of at least one of the agencies downgrading the UK in 2013 are very high.

For Messrs. Osborne and Cameron, this will undoubtedly be politically embarrassing. When they first came to power, they laid great store on the credibility of their austerity policy with the financial markets and the credit rating agencies. Since then, they have often sought to justify the policy by reference to the fact that the AAA rating has been maintained to date, while most Eurozone countries undergoing austerity programmes have seen their ratings reduced. The Labour Party will be able to score many political points, if and when a downgrade occurs.

For the financial markets, and indeed for the economy, it will, however, be of almost no significance. Markets are rarely surprised by downgrades to credit ratings, as the agencies telegraph their thinking some months ahead. Both the US and France have already lost their AAA status with at least one of the agencies, and it has had no obvious effect on yields on their government bonds. Indeed, French yields have fallen sharply since being downgraded.

For countries such as the UK and US, which have Central Banks who are allowed to print their own currencies, there is in fact no doubt that these governments will always repay their debts. They always have the power to create the money that is necessary to repay any debt denominated in their own currency. From the perspective of a domestic investor, there is no risk of not being paid back the nominal value of any government bond, and in that sense they should remain AAA. That is not of course the same thing as saying that these bonds have no risk, since creating a lot of money to repay government bonds is likely to prove very inflationary. Being repaid in devalued money can seriously damage an investor’s wealth.

For countries inside the Eurozone, matters are very different. By adopting the single currency, they have forsaken the right to be able to create the money to repay their debts and handed the right to the ECB, who hold a very strong conviction that creating money for such reasons is a very bad idea. It is thus entirely possible for a Eurozone country to find that it does not have enough euros to pay back its lenders, and thus go into default - hence the crises in Greek, Portugese and Spanish debt markets in the last few years.

One investment implication is likely to be a reversal in the strength of sterling that was seen in 2012, when it was the strongest of the major currencies over the year. Any downgrade itself is not likely to be the cause of sterling weakness, but both would reflect the poor growth performance of the UK economy. Further, David Cameron’s recent call for an in/out referendum on the UK’s membership of the EU, will create much uncertainty in the minds of global businesses and investors looking to invest in the UK. The pound looks set for a period of weakness, and investments overseas should benefit from currency gains for UK investors.