How to make the most from the UK’s weak fiscal position

Kathleen Brooks
CHANCELLOR Alistair Darling may have received jeers from the opposition while he delivered his Budget yesterday, but one thing all of the UK’s political parties agree on is that the projected £167bn budget deficit needs to be reduced.

While the proposed timing of the deficit reduction differs between the parties, public spending will get the chop no matter who is in power after the next general election. But what does this mean for investors?

Investment bank Goldman Sachs released a note before the chancellor’s Budget speech yesterday, which cautioned against trading government-spending-related investment themes.

But if you do this then make sure you do your research. The temptation might be to short companies that have a large exposure to government spending. Bovis Homes and defence company BAE Systems are just two British companies that rely on the UK government for more than 15 per cent of sales. However, frontline services are likely to be protected, so social housing and defence budgets could be saved from the chopping block by whoever is in power.

Due to this it’s important to differentiate between companies before you take a short position in them. For example Babcock International, the engineering and services company, derives 85 per cent of its sales from the British government and its revenues would be hit hard by a cut in government spending.

Rather than concentrate on individual companies, investors might prefer to look at an index. Goldman Sachs points out that domestic equity markets tend to perform well during periods of fiscal consolidation.

Goldman’s analysts looked at 25 developed countries that have been in the same position as the UK is now – about to embark on a deficit reduction programme – at some point during the last 35 years. It looked at the impact of these deficit reduction programmes on domestic equity markets.

Although equity markets perform well during periods of fiscal consolidation, the strength of the performance versus the world index depended on how the government chose to cut the deficit. Goldman found that when deficits were reduced through spending cuts rather than tax increases, during the first two years of cuts domestic equity markets rose by 56 per cent relative to the world index, in local currency terms. This compares with a more modest 17 per cent increase over the same time period when a government initiated tax increases.

Goldman suggests that the reason why markets rise during periods of fiscal consolidation is because deficits are viewed as a problem by global financial markets. So once steps are taken to address the budget shortfall the market rewards the domestic equity market, which bodes well for the FTSE 100.

Even if fiscal consolidation hurts the UK’s growth in the short-term, this should only have a limited impact on the financial performance of FTSE 100 companies. Further analysis by the US investment bank found that companies in the FTSE 100 had less than 20 per cent sales exposure to the UK, with the rest coming from Europe, America and emerging markets. So, as long as global growth does not falter then the FTSE 100 should do well.

In anticipation of spending cuts in the UK now is a good time to go long the index. It remains 1,000 points below its high of more than 6,500 reached at the market’s peak in 2007. And there is the potential for plenty more upside to come as the deficit slims down. Using an exchange-traded fund (ETF) is a relatively easy way to get exposure to all of the stocks in the FTSE 100.

An ETF is a good option for investors since it is relatively easy to close out of a position if it looks like the deficit reduction programme has been derailed.

The equity market won’t be driven entirely by the reduction in the deficit, but it could weigh on sentiment toward the UK. “If the government does not cut the deficit fast enough then this would be negative for the equity market,” says Manoj Ladwa, senior trader at ETX Capital.

While the chancellor and his team struggle with the debt mountain, investors can take advantage of the fact that the UK is poised to embark on a multi-year mission to bring the public finances to heel.