Q to reduce bonds

Investment Notes

In the 1970s, the British comedian, Spike Milligan devised the Q series. This was a surreal comedy show, which when any particular sketch had come to an end without a suitable punchline, the actors would then wander around saying “What are we going to do now?” UK economic policy seems to have reached the “What are we going to do now?” stage.

On fiscal policy, the coalition government has been and remains totally committed to reducing the budget deficit by a planned, slow but steady austerity approach. This initially involves an increase in taxes, followed by spending cuts throughout the life of this parliament and now extended well into the next parliament. Unfortunately, for the UK economy, this well-planned and thoughtful approach has not delivered the budget deficit reductions that were predicted for two main reasons as follows:

  • the eurozone crisis meant that the domestic economy of our nearest and largest trading partner was much weaker than expected as even more severe austerity was introduced there than in the UK.
  • all the economists’ models of how an economy performs at a time of government spending cutbacks woefully underestimated the impact of austerity on the overall economy. The result has been considerably weaker UK economic performance, and much higher budget deficits than forecast by the government.

None of the Chancellor’s choices on fiscal policy are politically appealing. Should he choose:

  • to cut spending faster than planned, to try and meet the deficit targets in future years, then even more public sector workers will be put out of work in the run-up to the next Election.
  • to reverse the spending cuts, then he will be accused of admitting that the austerity policy was wrong all along.
  • to do nothing, then he will be accused of having no ideas to boost the economy. Increasingly, with a little over two years to go until the election, these accusations are likely to come as much from his own MPs as from the Opposition.

With regard to monetary policy, Mervyn King, the current Governor of the Bank of England, has managed to thoroughly confuse everyone. For the last twelve months he has been saying that the policy of Quantitative Easing (in place since April 2009) is becoming progressively less effective and that monetary policy cannot solve all the UK’s economic problems. This is somewhat at variance with his confidence in the policies when they were initially unveiled. However, the latest minutes from the Monetary Policy Committee showed him in a minority of 3 (against 6), voting for more QE to stimulate the economy at a time when inflation is expected by the Bank to be above its target throughout the next two and a quarter years.

Further, the Chancellor, has asked the incoming governor to lead a debate to assess what the appropriate target of monetary policy should be. Taken all together, one gets the distinct impression that those in charge of UK economic policy have run out of ideas.

The investment implications of this uncertainty and indecision have already begun to be seen. Gilt yields have been rising, and sterling has been falling, evidence that international investors have been reducing holdings of UK government bonds. A weaker pound is however positive for the profits (in sterling terms) of many of the UK’s largest companies, and so share prices have been rising. The rise in government bond yields is likely to be mirrored by rising sterling corporate bond yields, and exposure to this asset class should be reduced.