On the evening of 13 February, credit ratings agency Moody's moved the UK, France and Austria to a negative outlook, raising the prospect that these three countries could lose their top "AAA" credit-rating status.
Moody's cited the high risk of further shocks in the Eurozone and considerable uncertainty over the prospects for institutional reform in the Euro area as the primary reasons for moving all three countries to a negative outlook.
In relation to the UK, Moody's also warned about rising challenges in achieving debt reduction targets within the timeframe that has been laid out by the government, "not least the possible impact of any future cutbacks on short-term growth". This follows last month's release of disappointing UK GDP growth figures for the fourth quarter of 2011, which showed economic contraction of 0.2%, below market expectations of a 0.1% fall.
We have expressed concern for some time that the policy mix in the UK is overly aggressive. Although superficially the UK is better placed than Eurozone countries, it is far from immune to contractionary economic forces. To date, the government's ambitious fiscal consolidation programme has been meeting and even exceeding debt reduction forecasts. However, as Moody's have just confirmed, the general economic environment remains very challenging. Against this backdrop, austerity measures which harm economic growth could, in themselves, make hitting debt reduction targets harder.
Hampered by slow demand from the Eurozone, the UK government now faces the uncomfortable choice of deciding whether to continue down the same path and risk a credit downgrade, or change tack and risk the wrath of bond vigilantes. For the moment, we believe that although Gilt yields are still close to record low levels, they remain supported by the prospect of further quantitative easing. However, we should not forget that 30% of the UK bond market is held by overseas investors. Those investments, and the position of Sterling, are therefore potentially at risk if the UK loses its position as a perceived "safe haven", a status which looks increasingly questionable, in our view.
Alan Wilde
Head of Fixed Income & Currency,
Baring Asset Management, London
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