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Severe austerity measures the lesser of two evils, says Newton’s Cunningham

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David Cameron’s high profile speech earlier this week set the tone of his premiership, reiterating the urgent need for austerity and tough decisions as the government sets about slashing its burgeoning fiscal deficit.

The coalition government announced departmental cuts worth GBP6.2bn a few weeks ago, but this only amounted to 0.4 per cent of GDP – the fiscal deficit currently stands at 11.1 per cent of GDP.

Howard Cunningham, manager of the Newton Corporate Bond Fund, says it was a symbolic move nevertheless – a show of intent aimed at easing market concerns and to some extent it has achieved that aim.

UK gilt prices have fallen since the formation of the new government, while at the weekend the G20 publicly backed the UK government’s approach. Meanwhile, the credit rating agency Fitch praised the new UK government’s prompt action yesterday, although these comments were tempered by a warning that the UK’s fiscal challenges remain “formidable”. 
 
“There was also a marked change in tone from the G20; having supported the raft of extensive fiscal and monetary stimulus measures put in place globally over the past two years, the buzzword is no longer ‘stimulus’ but ‘austerity’,” says Cunningham. “In short, the levels of stimulus that have been seen over this period simply aren’t sustainable and the money has run out. Governments are now faced with two options, to accept the inevitable pain, both economically and politically, and take on severe austerity measures, or to stick with the status quo and risk the consequences of a ‘Greece situation’ where it was the markets which forced cuts upon its beleaguered economy.” 
 
The UK’s coalition government is faced with implementing the worst public sector cuts in a generation and Cunningham says it is of paramount importance that it gains the support of the electorate for the sake of both the economy and for its own political future.

“The Prime Minister said on Tuesday that things were ‘worse than we thought’, but the reaction of the bond markets would suggest that there are no great negative surprises around the corner. As such, the doom-mongering emanating from 10 Downing Street should be taken with a pinch of salt, but who wouldn’t wish to pin the blame for future pain on their predecessors?” asks Cunningham.
 
“Evidently there are real risks that by making drastic cuts now, the economic recovery might be put into reverse and we might be faced with a ‘double-dip’ recession. However, the alternative is to hold fire and risk becoming the next Greece and being tarnished with that unenviable brush. In effect, the path chosen by the coalition is the lesser of two evils.

“The most recent Labour budget forecast that the UK debt to GDP ratio will still be rising in 2015, the current annual interest repayments (not actually reducing the debt) are the equivalent of the government’s education budget, and it is predicted that these repayments will rise to a staggering GBP70bn in four years time; the need for action couldn’t be much clearer,” adds Cunningham. 
 
He says the manner of the coalition’s approach to its austerity measures will be absolutely key to their success. As yet, with the exception of the GBP6.2bn already announced, there have been no concrete plans set out.

“While the last Labour budget was, in light of the election result, fairly meaningless, the forthcoming budget on 22 June is the real deal. As such, it needs to be clear and transparent, based on realistic and achievable targets, and with a concise timescale for the implementation of these measures over the coming months and years,” says Cunningham.

“Furthermore, there will need to be a delicate balancing act between cuts/tax rises and continuing to provide a fertile environment for economic growth – an 80:20 split between spending cuts and tax increases should help achieve this.” 
 
After years of loose fiscal and monetary policy, there is little doubt that a shift to austerity will have serious impacts on the economy. To offset these, it will necessitate a significant period of very low interest rates as public sector pay and disposable incomes embark on a downward trajectory.

However, Cunningham believes this should provide a healthy environment for bonds as inflation is likely to be low for some time to come.

“Corporate bonds may struggle in the short term as fiscal tightening drags on the economy,” he adds, “but in a low inflation and interest rate environment, we expect corporates to offer significant value, while we also expect to see a more conservative approach from many companies as credit quality becomes ever more important.”

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