This is a useful pointer of what will be significant on Wednesday, and how to interpret it.
Christina
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SUNDAY TELEGRAPH 6.12.09
The time for action, not words, has come
How will the markets react to next week's pre-Budget report (PBR)?
By Tom Stevenson
With the public finances in a mess and the policy response to them set to determine our domestic economic fate for years to come, it might be expected that investors will be glued to screens on Wednesday. I suspect the reality will be less exciting for two reasons.
The first is the imminence of next year's election. With the polls pointing to a close result, it is increasingly clear that the difficult decisions will be parked until next summer. While the electorate deserves a clear explanation of the tax and spending choices that lie ahead, the political reality is that they might not get it.
The second reason is that, with the exception of gilts and sterling, today's globalised markets are largely indifferent to the purely domestic matters that are the subject of the PBR. City traders will be more interested in the extent to which the Government decides it is politically expedient to soak the rich than in knee-jerk portfolio management.
This is not to say that the big fiscal issues the Chancellor must address next week are not important. The UK's budget deficit is very likely to exceed the £175bn total forecast in the April 2009 Budget and could reach £200bn. The lower figure would represent easily the biggest gap between tax revenues and spending since the Second World War.
Even if the Government achieves its target of halving the deficit by 2013/14, national debt will represent 75pc of GDP by then. Holding the line there will be no mean feat either – it implies a deficit reduction equivalent to 7pc of GDP.
Failure to tackle the deficit would result in public sector debt matching national income by the middle of the next decade.
The current situation is unsustainable. The remedial options are clear – taxes must rise or spending must fall or a combination of the two. But how quickly should the deficit be reined in and which of tax or spending should be relied on to do the heavy lifting?
On the first of these, there is clear blue water between the Government and Opposition.
Labour's plan envisages no real reduction in the deficit in 2010/11 on the grounds that attempting too much too soon will repeat the mistakes of America in the 1930s and Japan in the 1990s when fragile recoveries were snuffed out by premature tightening.
The counter argument, favoured by the Conservatives, is that a government which does not choose to get its fiscal house in order will be forced to do so by the markets.
If international investors take fright at the Government's inactivity, bond yields will rise sharply, the currency will fall and the end result will be no less messy. It's a high stakes version of St Augustine's prayer – "make me good but not just yet" – and one in which I think the risks of waiting are greater than of getting on with it. There is evidence, moreover, that early fiscal consolidation can lead to a stronger recovery, especially if it allows interest rates to stay lower than would otherwise have been the case.
This is all the more so if spending cuts and not tax rises take most of the strain. On the balance between these two there is more agreement, which is fortunate because a study of recent fiscal retrenchments in both the UK and elsewhere has shown that the most successful consolidations have seen spending cuts carry around 80pc of the burden and tax rises just 20pc. The Policy Exchange analysis suggests that when governments have reversed these weightings, the improvements in the public finances were not sustainable.
The markets to watch next week are, in order of likely impact, sterling, UK gilts and only then equities. For the pound, there are two risks: first, that investors lose faith in the Government's ability to get the public finances back on track; second, that the Chancellor reassures voters and the likelihood of a hung parliament increases. Neither argues for a strengthening pound.
For gilts, it is more clear-cut. A realistic plan to bring the deficit down in an orderly fashion will be taken well by fixed-income investors; signs of drift, by contrast, will be punished. Even if the plan implies an increased risk of a slide back into recession or prolonged anaemic growth, gilts could be a relative winner.
As for the equity market, any significant move next week is unlikely to be a result of anything Mr Darling has to say. With two-thirds of the earnings of the FTSE 100 made overseas, Goldman Sachs's recent upward revision of its global growth forecast matters rather more than anything that will be delivered at the despatch box.
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Tom Stevenson is an investment commentator at Fidelity International. The views expressed are his own.
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