Keep Calm and Carry On

Simon Lewis explains why investors should not panic, whatever the outcome of the UK’s General Election …

The only certainty of recent polls is that the outcome of the General Election is uncertain and if there is one thing that investors don’t like, it is uncertainty. It might therefore be fair to conclude that the coming weeks are likely to provide investors with a bumpy ride.

It is no wonder that the electorate is struggling to make up its mind. The last few weeks have heralded a bewildering and incoherent succession of promised giveaways to tempt fickle voters. Like a line of magicians frantically pulling rabbits out of hats in the hope of drawing applause.

Election campaigns have become so carefully stage managed, so laden with populist sound bites and so full of gimmicks that there has been very little debate about some of the more fundamental financial issues. It is such issues that predominantly occupy the thoughts of investors, remembering that ‘investors’ refers to a diverse group of individuals, institutions and governments around the world.

Whatever its political persuasion, there is no escaping the fact that government needs revenue to go about its business and implement its policies and such revenue is a simple determination of current tax receipts minus the cost of servicing existing debt.

The higher the debt, the higher the servicing cost, which means the more that needs to be raised from taxation if government spending is not to be reduced. It is important to appreciate that this relationship is not simply linear. The higher the debt, the greater the risk of default, which in turn means the higher the rate of interest demanded by the country’s creditors. In other words, the impact of additional government borrowing, over and above that deemed comfortably sustainable by financial markets is likely to be disproportionate in terms of the future cost to tax payers.

The difference in manifesto pledges between the main parties amounts to £90 billion of additional national debt over the course of the next parliament. It must be remembered that the Government is already borrowing around £90 billion this year to meet current spending (the fiscal deficit) so debt is going to continue to increase unless a fairy godmother wins the election.

As described by the Chief Executive of the largest global asset manager, the UK is dependent upon the kindness of strangers, which reflects the fact that approaching half of the UK’s national debt is owned by overseas investors (creditors). It is evident that the Greeks do not enjoy being bounced around by their creditors and we have to think about whether we want to risk putting ourselves in a similar position, even if it is to a much lesser extent.

It is easy to become blasé about big numbers because politicians toss them around with abandon. However, there is no escaping the fact that £90 billion is a lot of money for a nation the size of the UK.

Quantitative easing by the Bank of England (and other central banks) has acted to suppress interest rates and therefore reduce the cost of borrowing. In such circumstances, a prudent budgeter would use the reduction in interest payments to repay part of the amount owed.

However, it is easy to find excuses to justify imprudence. For example, the cost of government borrowing over 20 years is currently ‘only’ 2.4% per annum, so why not take advantage of cheap rates? The reality of course is that more money to spend now means less money to spend later. Even at 2.4%, additional debt of £90 billion equates to additional interest of £2.25 billion every year and this cost could easily double when the debt is refinanced on maturity.

Despite the above, global financial markets have many other anxieties to live with at present so in reality, we might be surprised by how muted the immediate reaction may be, beyond a modest slide in sterling if investors do not approve of the outcome.

So what are the factors that I think are going to have the biggest impact on UK investors over the course of the next 6 months?

In order of impact:

  • Greek default – will they or won’t they?
  • US Federal Reserve monetary policy – will interest rates rise?
  • Eurozone economic growth – will it continue to recover?
  • Chinese economic growth – will it stabilise?
  • UK General Election – who will form a Government and what policies will be set out in the Queen’s speech?

Keep calm and carry on…