From Markit:
Not long after his election as leader of the Conservative Party in 2005, David Cameron vowed to end the “Punch and Judy” style of British politics. Voters found the confrontational debates alienating and increased apathy, a charge difficult to refute. But even the most casual observer would know that Cameron has long since abandoned his pledge. This week saw the latest in long line of aggressive, sometimes personal attacks on the Prime Minister Gordon Brown. In normal times the financial markets would pay little heed to such events. But the issue at the centre of the debate – government finances – is one that investors are very much aware of.
Both parties are trying to paint the other as the party of cuts. Labour accuses the Conservatives of preparing swingeing 10% cuts across the board after the 2010 general election, while the Tories say Labour is guilty of prestidigitation in its declaration of real spending increases over the next few years. Voters are unlikely to have been impressed by the immaturity of the debate and investors even less so. Most recognise that a fiscal stimulus was necessary in a recession to compensate for the shortfall in private consumption. But the OECD’s prediction this week of a 14% budget deficit in 2010, compared to the government’s prediction of just over 12%, highlighted the need for urgent action in getting government finances back in line.
Mervyn King, the Governor of the Bank of England, called the scale of the deficit “truly extraordinary”. King highlighted the importance of fiscal policy credibility in raising funds to finance the deficit. UK sovereign CDS spreads have been creeping up in recent weeks, reflecting the economic uncertainty prevailing in the current climate. However, they are significantly lower than levels reached earlier this year, and the UK government is having little difficulty in issuing gilts at the moment. Nonetheless, most investors would concur with King’s sentiments and appreciate concrete plans to cut public spending when the recovery in entrenched. The chances of them getting this in the months approaching a general election are, however, remote.
The UK is not alone in its predicament. Ireland is in an even worse situation. It also has a gargantuan deficit – 12% this year, according to the IMF this week – and a crippled banking sector. But the problems are far more acute, and the country faces years of pain in trying to stabilise the economy. The government has responded to the crisis by raising taxes, a questionable strategy deep in a recession. Like Britain, there is no realistic proposition of default in the medium-term. But it has been downgrade to AA, and further downgrades could follow if it doesn’t take more drastic action in cutting public spending. The concern is reflected in Ireland’s CDS levels, the widest in the eurozone.
That is a surprising statistic for one of the world’s wealthiest countries. The chart above reveals an even more striking comparison. Ireland is now trading wider than India, a developing country with a GDP per capital only 6% of the western nation. The UK also compares unfavourably with the other Asian giant. China is now trading tighter than Britain, a position that would have seemed ludicrous only two years ago. A controversial book “When China Rules the World” by Martin Jacques has provoked much debate in the UK this week. While the CDS market is not irrefutable, skeptics of the book’s title would be wise to pay attention.
Source: Markit Research
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.