Why Moody’s downgrade of UK sovereign debt is meaningless
Moody’s took away the UK’s triple A rating late Friday. A ratings downgrade has long been rumored, and although the timing is always surprising, the move itself has long been anticipated. Sterling slumped on the news in thin dealings, losing a cent in about 30 minutes.
When it comes to corporate ratings we can appreciate that rating agencies may have access to private information. They may also be of value in some developing countries, where information is more difficult to secure. However, when it comes to large developed countries, the rating agencies have access only to public information and it is the same information that investors use to make their decisions.
That there is extremely little value-added or new information contained in a rating agency is evident in the lack of market response to downgrades of Japan, the US, Austria, and France, for example. There is little reason to expect the UK to be an exception to the rule.
Some observers are claiming the loss of the UK’s AAA rating is a serious blow to the UK government, but we are less convinced. It is true that UK Prime Minister Cameron and Chancellor of the Exchequer Osborne had hoped its efforts to address the UK’s debt and deficit would have averted a downgrade. The downgrade is not going to deter them from the austerity path upon which they have embarked.
It is politically naive to think see the downgrade as some opportunity for them to change course. They have rejected the IMF’s calls to slow the austerity drive. What they did not surrender to the IMF, they will not yield to Moody’s or the government’s critics who what to use the downgrade to bludgeon the government into accepting its critic’s, including the Labour Party’s agenda.
Reviewing the rationale behind Moody’s decision is like understanding a set of economists’ views. It is a narrative constructed around well known facts. The global economic weakness, especially in the euro area, and the “ongoing domestic public- and private-sector de-leveraging process” is generating poor growth in the UK and this may persist, Moody’s says into the second half of the decade.
The weaker growth means that the debt/GDP ratio will remain elevated for longer. Moody’s doesn’t expect it to peak until 2016. The slower growth and higher debt ratio, in turn, means that the UK’s ability to absorb additional future shocks is more limited.
Most investors will find nothing new in that assessment. Ironically, Moody’s demonstrated its firm grasp of the obvious the same day that the EU provided updated its forecasts. It expects the UK economy to expand by 0.9% this year, compared with a 0.3% contraction in the euro zone, which incidentally absorbs 40% of the UK’s exports.
Lost in the initial reaction by many observers who wrung their hands at the downgrade, Moody’s reverted back to a stable outlook for UK debt and the rationale appears to also be shared by many investors. Simply, even if crudely put, the UK is not Greece. It has a highly diversified economy and strong institutions. It has a favorable debt structure. The average maturity of its debt at 15 years is the highest among the highly rated sovereigns. Its debt servicing capacity remains very strong.
Indeed, reading between the lines of Moody’s assessment suggests that, arguably, if UK government were to dilute its efforts to address the country’s debt and deficits, Moody’s may not have been so inclined to offer a stable outlook.
From a policy point of view, Cameron’s commitment to austerity is taken as given, then any change must come through two other channels: monetary policy and the currency. We learned in recent days that BOE Governor King was out-voted for the fourth time in his tenure. He wanted to resume gilt purchases. As has often been the case, he will likely get what he wants. When Carney takes the helm in July, he also may be inclined to ease policy and it will be interesting to see if he is as tolerant of being outvoted.
Sterling has fallen 6.7% against the dollar, second among the major currencies to the yen which has lost 7.1% year-to-date. It has declined about 6% on the BOE’s broad trade-weighted measure. Just like the difference between expansion of the Federal Reserve’s balance sheet relative to the BOE’s balance sheet cannot explain this decline in sterling, so too sterling’s decline may not boost exports as much as some, especially those who have focused on currencies wars, would suspect.
There are several reasons for this counter-intuitive assertion. First, surely we can all agree that foreign demand is important. As we have noted, a major market for UK goods, the euro area, is expected to contract this year. The US is also expected to slow from near 2% pace it has averaged since the economy bottomed nearly four years ago.
Second, the restructuring of the UK’s financial sector and the changes in the globally, may curb its ability to export financial services. Third, for many goods, there are important non-price dimensions to competitiveness, such a quality, design, speed of service, which will not be impacted by sterling’s decline.
What this all means is that the UK’s exports may be sufficiently sensitive to sterling’s exchange rate to allow exports to replace the domestic aggregate demand being squeezed by the de-leveraging of the government and households.
From an investment point of view, we prefer UK equities over bonds. The FTSE 100 has a dividend yield of 3.7%, while the 10-year bond yields about 2.1% Sterling’s broad trade-weighted index is the most inversely correlated to the FTSE 100 since early 2007 near -0.44 on a 60-day rolling basis using percent change. Running the correlation on simply the level of the FTSE 100 and the trade-weighted index is near 0.93, the highest since late-2004. The sterling-dollar rate is (on a 60-day percent basis) about 0.71 correlated with the trade weighted measure.