U.K. Bondholders Condone Stimulus Cameron Snubs for Growth

U.K. Prime Minister David Cameron
David Cameron, U.K. prime minister. Photographer: Scott Eells/Bloomberg

U.K. bondholders say David Cameron can relax his plan to cut Britain’s budget deficit, easing the austerity measures that defined his first 2 1/2 years as prime minister and helped gilts outperform U.S. and German peers.

Investors whose companies manage $5.2 trillion said they may keep buying British debt even if Cameron pulls back from the largest budget reduction since World War II, according to a Bloomberg News survey. U.K. bonds returned 26 percent since he took office in May 2010, beating a 14.8 percent gain from Treasuries and bunds’ 14.5 percent advance, based on Bank of America Merrill Lynch indexes.

As Britain struggles to emerge from a double-dip recession, the Conservative-led coalition is bracing for a round of party conferences starting tomorrow that may question its insistence on eliminating the bulk of the deficit by 2017 with spending cuts and tax increases. This year’s target is for a shortfall of about 7.5 percent of gross domestic product. Investors’ willingness to tolerate a strategy change challenges Cameron’s claim that any deviation will spark selling and drive up yields.

“The key is to have a clear sense that there’s a credible effort to put the U.K. fiscal situation back on an even keel,” Adrian Grey, a fund manager at Insight Investment Ltd., who helps oversee $295 billion, said in a phone interview. “Over time, that has to involve retrenchment, but it doesn’t have to be done by next week. If it’s one or two years more on the back end, and there’s a clear indication of the reason for spending more, that’s not a big problem.”

Strategy Shift

Grey was one of 16 investors, among the biggest owners of gilts, who participated in the survey. Ten said a shift in government strategy on the fiscal plan may not trigger a decision to reduce holdings. Six of the respondents, who oversee less than $1 trillion, said they’d sell on a change in plan.

The U.K. has recovered less than one third of the output lost in the recession of 2008-2009. Gross domestic product shrank 0.5 percent in the three months through June, the third consecutive quarter of contraction in the country’s first double-dip recession since the 1970s. U.S. GDP climbed at a 1.7 percent annual rate from April through June. The euro-area economy shrank 0.2 percent from the first quarter, when it stagnated.

Gilt Yields

Since Cameron’s government came to power on May 11, 2010, the 10-year bond yield has fallen to 1.83 percent at today’s 5 p.m. close in London, from 3.89 percent. It dropped to a record 1.407 percent on July 23. The U.K. sold gilts maturing in September 2017 at an average yield of 0.802 percent yesterday, the second-lowest rate at an auction of five-year notes since Bloomberg started compiling the data in 1999. The Bank of England is buying 375 billion pounds ($609 billion) of debt to revive growth, adding support for gilts.

Demand for British assets also helped the pound appreciate 4 percent against nine developed-nation peers in the past year, the best performer, according to Bloomberg Correlation-Weighted Indexes. Sterling appreciated as much as 0.6 percent to $1.6309 today, the strongest level since Aug. 31, 2011.

The prime minister has taken credit for the decline in borrowing costs, saying his austerity plan shielded Britain from the euro area’s debt crisis. While U.K. and Spanish yields were equal when the coalition took office, Britain’s rate has dropped because of the government’s efforts, Cameron wrote in the Mail on Sunday newspaper Sept. 2. The coalition has cut the deficit by a quarter already, and it’s sticking to that course, he said.

Change Course

The government earlier this year froze pensioners’ tax allowances, adding to austerity measures since it took office including shrinking the payroll and leaving public-sector pay unchanged.

“The government was right to set out a multiyear plan to deal with the deficit,” said Michael Amey, a portfolio manager at Pacific Investment Management Co. in London. “Now that growth has continued to disappoint, there is a good case for higher spending in public-sector investment.”

Calls for Cameron to change course have mounted. The International Monetary Fund said in July the government may need to ease policy if growth doesn’t build momentum by early 2013. While that “would likely entail the government reneging on its net debt mandate,” there is “little evidence” this would trigger major market turmoil, it said.

‘Drastic Cuts’

Bank of England Governor Mervyn King said yesterday in a television interview on Channel 4 it would be acceptable for the government to miss its debt-reduction targets if it was caused by a weaker-than-expected economy.

“Every government has to cut spending, but too many cuts may slow the economy,” said Yoshiyuki Suzuki, head of fixed-income in Tokyo at Fukoku Mutual Life Insurance Co., which has $70 billion. “The government should cut but it should be moderate. Drastic cuts are not good.”

Britain’s deficit is projected by the Office for Budget Responsibility to be 120 billion pounds this year. That’s down from 125 billion pounds last year, while the goal is to reach 21 billion pounds, or 1.1 percent of GDP, by 2017.

Data today showed the U.K. posted its biggest August budget deficit on record as the recession hit tax revenue and pushed up spending on welfare. The shortfall excluding government support for banks was 14.4 billion pounds, the Office for National Statistics said in London.

Sales Trigger

A failure to control the shortfall risks landing Britain with a spiraling debt burden. Altering policy may also jeopardize the U.K.’s top credit rating. The grade has a negative outlook at Moody’s Investors Service and Fitch Ratings, and a stable outlook at Standard & Poor’s.

“A change in stance could lead to an increase in risk premia and a loss of confidence by markets,” said Dagmar Dvorak, a director of fixed-income and currencies at Baring Asset Management in London, which has $50 billion. “I would probably see it as a trigger to reduce my exposure.”

Some money managers say Chancellor of the Exchequer George Osborne’s budget plans are beside the point since the Bank of England’s asset purchases may limit increases in yields. The central bank will finish its plan to buy debt by November, and minutes of this month’s policy decision to leave the plan unchanged showed some officials said additional stimulus “was more likely than not to be needed.”

Stimulus Measures

“If the government were to loosen the pace of fiscal consolidation, that would ordinarily be met by an increase in the supply of gilts,” Mitul Patel, a fund manager at Henderson Global Investors Ltd. in London, which has $103 billion under management, said in a phone interview. “However, if the BOE are also buying significant quantities of government bonds at the same time, that would probably limit the extent of the rise in gilt yields.”

Others downplay the importance of government plans in setting their strategy. “U.K. fiscal policy has little bearing on gilt performance” and the global economic outlook is among the biggest reasons to change position, said Michael Riddel, a London-based fund manager at M&G Group Plc, which oversees about $324 billion.

Some Conservatives are proposing steps to revive growth, such as making it easier to fire staff. Business Secretary Vince Cable, a Liberal Democrat member of the coalition, has rejected such proposals, saying they’ll damage confidence. His party’s annual conference starts tomorrow, and the Conservatives’ begins Oct. 7. The opposition Labour Party, which has called for tax cuts and more spending on infrastructure, gathers on Sept. 30.

“We will still keep what we have if the government decides to increase spending to promote growth,” said Robin Marshall, a director of fixed-income at Smith & Williamson Investment Management in London. “We will only sell if the shift in policy produces results and leads to growth picking up at a decent pace. I don’t think that’s likely to be the case.”

The following investors participated in the survey:

AllianceBernstein Ltd. 
Baring Asset Management 
BlueBay Asset Management Ltd. 
Diam Co. 
Fidelity Investments 
Fukoku Mutual Life Insurance Co. 
Henderson Global Investors Ltd. 
Ignis Asset Management 
Insight Investment Management Ltd. 
Investec Asset Management Ltd. 
Legal & General Investment Management Ltd. 
M&G Group Plc 
Pacific Investment Management Co. 
Royal London Asset Management Ltd. 
Smith & Williamson Investment Management
Standard Life Investments
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