Moody’s Blues - Why The UK Downgrade Was Meaningless: Marc Chandler

February 27, 2013United Kingdomby Marc Chandler

Moody’s Blues: Why The UK Downgrade Is Meaningless

Last Friday, the U.K. lost its much-treasured AAA rating, after Moody’s downgraded its sovereign debt on the back of poor economic growth forecasts. But while the timing of the downgrade was surprising, the move itself was long anticipated – and is unlikely to see the government, nor investors, change their opinions for the future.

Moody's took away the U.K.'s triple A rating late Friday. A ratings downgrade has long been rumored, and although the timing is always surprising, the move itself has long been anticipated. Sterling slumped on the news in thin dealings, losing a cent in about 30 minutes.

When it comes to corporate ratings we can appreciate that rating agencies may have access to private information.  They may also be of value in some developing countries, where information is more difficult to secure.  However, when it comes to large developed countries, the rating agencies have access only to public information and it is the same information that investors use to make their decisions. 

That there is extremely little value-added or new information contained in a rating agency is evident in the lack of market response to downgrades of Japan, the U.S., Austria, and France, for example.  There is little reason to expect the U.K. to be an exception to the rule.

Some observers are claiming the loss of the U.K.'s AAA rating is a serious blow to the U.K. government, but we are less convinced.  It is true that U.K. Prime Minister Cameron and Chancellor of the Exchequer Osborne had hoped its efforts to address the U.K.'s debt and deficit would have averted a downgrade.  The downgrade is not going to deter them from the austerity path upon which they have embarked. 

It is politically naive to see the downgrade as some opportunity for them to change course.  They have rejected the IMF's calls to slow the austerity drive; They did not surrender to the IMF, they will not yield to Moody's, or the government's critics, who want to use the downgrade to bludgeon the government into accepting its criticism, including the Labour Party's agenda.

Related: UK Economy To Face Decade Of Austerity: CEBR Report

Related: UK’s "Era Of Austerity" Could Last Until 2018, Warns Think-Tank

Reviewing the rationale behind Moody's decision is like understanding a set of economists' views.  It is a narrative constructed around well-known facts.  The global economic weakness, especially in the euro area, and the "ongoing domestic public- and private-sector de-leveraging process" is generating poor growth in the U.K. and this may persist, Moody's says into the second half of the decade.  

The weaker growth means that the debt/GDP ratio will remain elevated for longer.  Moody's doesn't expect it to peak until 2016.  The slower growth and higher debt ratio, in turn, means that the U.K.'s ability to absorb additional future shocks is more limited. 

Most investors will find nothing new in that assessment. Ironically, Moody's demonstrated its firm grasp of the obvious the same day that the EU provided updated its forecasts.  It expects the U.K. economy to expand by 0.9 percent this year, compared with a 0.3 percent contraction in the euro zone, which incidentally absorbs 40 percent of the U.K.'s exports.

Lost in the initial reaction by many observers who wrung their hands at the downgrade, Moody's reverted back to a stable outlook for U.K. debt and the rationale appears to also be shared by many investors.  Simply put, the U.K. is not Greece.  It has a highly diversified economy and strong institutions; and it has a favorable debt structure.  The average maturity of its debt at 15 years is the highest among the highly rated sovereigns.  It debt servicing capacity remains very strong. 

Indeed, reading between the lines of Moody's assessment suggests that, arguably, if U.K. government were to dilute its efforts to address the country's debt and deficits, Moody's may not have been so inclined to offer a stable outlook. 

Related: Ten Things You Probably Don't Know About Credit Rating Agencies

Related: Appetite For Self-Destruction: Have Rating Agencies Lost The Plot?

Related: Rating Agencies De-Stabilize Shaky World Political Economy

From a policy point of view, Cameron's commitment to austerity is taken as given, then any change must come through two other channels: monetary policy and the currency.  We learned in recent days that BOE Governor King was out-voted for the fourth time in his tenure.  He wanted to resume gilt purchases.  As has often been the case, he will likely get what he wants.  When Carney takes the helm in July, he also may be inclined to ease policy and it will be interesting to see if he is as tolerant of being outvoted. 

Sterling has fallen 6.7 percent against the dollar, second among the major currencies to the yen which has lost 7.1 percent year-to-date.  It has declined about 6 percent on the BOE's broad trade-weighted measure.  Just like the difference between expansion of the Federal Reserve's balance sheet relative to the BOE's balance sheet cannot explain this decline in sterling, so too sterling's decline may not boost exports as much as some, especially those who have focused on currencies wars, would suspect. 

There are several reasons for this counter-intuitive assertion.  First, surely we can all agree that foreign demand is important.  As we have noted, a major market for U.K. goods, the euro area, is expected to contract this year.  The US is also expected to slow from near 2 percent pace it has averaged since the economy bottomed nearly four years ago. 

Second, the restructuring of the U.K.'s financial sector and the changes in the globally, may curb its ability to export financial services.  Third, for many goods, there are important non-price dimensions to competitiveness, such a quality, design, speed of service, which will not be impacted by sterling's decline. 

What this all means is that the U.K.'s exports may be insufficiently sensitive to sterling's exchange rate to allow exports to replace the domestic aggregate demand being squeezed by the de-leveraging of the government and households. 

Related: Britain’s Massive Pension Debt: An Impossible Dilemma For The Government?

Related: UK Economy

Related: UK Economic Forecast

From an investment point of view, we prefer U.K. equities over bonds.  The FTSE 100 has a dividend yield of 3.7 percent, while the 10-year bond yields about 2.1 percent.  Sterling's broad trade-weighted index is the most inversely correlated to the FTSE 100 since early 2007 near -0.44 on a 60-day rolling basis using percent change.  Running the correlation on simply the level of the FTSE 100 and the trade-weighted index is near 0.93, the highest since late-2004.  The sterling-dollar rate is (on a 60-day percent basis) about 0.71 correlated with the trade weighted measure. 

By Marc Chandler

Marc Chandler is the current Global Head of Currency Strategy at Brown Brothers Harriman in October 2005. Previously he was the chief currency strategist for HSBC Bank USA and BNY Mellon. In addition to being quoted in the financial press daily, Chandler has been published in the Financial Times, Foreign Affairs, and the Washington Post. In 2009 Chandler was named a Business Visionary by Forbes.

The Meaning of Moody's Downgrade of the UK: Nothing is republished with permission from Marc to Market.

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