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Bed of nitroglycerine? That's just what the sick UK economy needs

M&G fixed income fund manager, Citywire AA-rated Richard Woolnough, has challenged Bill Gross' view that gilts should be avoided at all costs as they rest 'on a bed of nitroglycerine.'

Bed of nitroglycerine? That's just what the sick UK economy needs

M&G fixed income fund manager Richard Woolnough (above) has challenged Bill Gross' view that gilts should be avoided at all costs as they rest 'on a bed of nitroglycerine.'

In his monthly investment outlook, Pimco's Gross said high debt in the UK, along with the potential for currency devaluation, means gilts are a must avoid.

While Citywire AA-rated Woolnough accepts this may be the case in the short term, over the long term he paints a different picture.

Woolnough writes: According to many market commentators, the UK debt market is looking sick and is at a critical juncture. It is amongst the most unloved government markets in the developed world, which is understandable given the British inability to save in the boom times. 

Now there is justifiable scepticism that markets will not be able to absorb the forthcoming huge government debt issuance once the Bank of England stops providing life support to the gilt market when it ends the quantitative easing program.

This consensus view is typified in Pimco's monthly investment outlook in which the UK bond market is singled out as a market that must be avoided. In their opinion, the gilt market is resting on a bed of nitroglycerin.

Pimco point to the UK's relatively high level of government debt, potential for sterling to fall and domestic accounting standards that have driven real yields on long dated inflation linked bonds to exceptionally low levels. 
We agree these are issues that face the UK economy and have commented on these points previously. However, like any consensus, it makes sense to investigate if this is correct, priced in, and when it might come to an end.

Firstly, the IMF forecasts that for 2009 that the UK government will have a relatively large annual deficit of -11.5% of GDP, which is below that of the USA (-12.5%) but almost triple Germany’s government deficit (-4.2%). However the UK’s total outstanding gross debt stands at 68.7% of GDP, which compares favourably with the USA (84.8%) and Germany (78.7%).

The UK government has responded in aggressive Keynesian fashion to the downturn, if this medicine works then the action will be short term in its nature and will not leave the UK with a permanent debt burden, or the increase in debt could alternately be curtailed by the arrival of a more fiscally stringent government in this year’s election.

The UK has very little foreign debt and has been prudent by having the longest maturity debt profile in the G7. Outstanding debt and re-financing needs would therefore appear relatively manageable on an international basis. Not all outcomes will be bad.

Secondly, with regard to fears that our exchange rate could fall, the exchange rate has already collapsed by 22% on a trade weighted basis since 31 July 07.  So a lot of the necessary adjustment has already taken place.

This adjustment process is very beneficial for an open economy such as the UK, especially when many of our trading partners are locked into using the relatively strong Euro currency. By having a flexible currency and control over domestic interest rates, the UK is arguably in as good a position as anyone to grow our way out of our debt problem.

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1 comment so far. Why not have your say?

mark wild

Jan 29, 2010 at 16:39

Gilts are probably oversold as is sterling given a near quarter of its weighted value has gone now thats a haircut for a AAA rated product.

The question will sterling take more haircuts or recover and the answer is both.

Gordon Brown made a good statement a long time ago A countries Currency is only as good as the economy supporting it.

If anyone thinks a 70% of a countries economy that is the consumer driven as the UK is and almost daily jobs losses are made due to offshoring etc the real economy of the UK is being gutted piece by piece hence higher and higher debts so the longterm trend for sterling is down until the offshoring megatrend starts to reverse which will need a 50% further haircut to even start to slow the trend.

A cheap washing machine can be purchased retail for under £200 imported offcourse when sterling is devalued to its real value than the same washer will cost near£500 to £1000 but at this price it would become possible to actually make the unit here and then at that point the gutting of the UK economy will reverse back to the UK and a long term buy for sterling however I dont think sterling will exist we will of sold out to the the European government.

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