The UK’s debt level is likely to remain at the top of the political agenda in the run up to this year’s General Election, with the two major parties proposing differing solutions to the burgeoning deficit. But what is the impact of the deficit on financial markets?
Despite extensive intervention by the Bank of England, known as Quantitative Easing, having helped the UK to a modest 0.1% rise in GDP at the end of 2009, the BoE has started to rein in stimulus over the past two months, partly due to concerns that printing more money will lead to dangerous levels of inflation.
The central bank’s decision to wind down the large-scale purchase of government debt has led to fears that interest rates on government bonds could spiral as their price drops. If no major investors step into the central bank’s shoes to continue to fund the deficit through the purchase of government gilts, the cost of keeping up deficit payments would increase. On the other hand, even the spectre of further intervention by the BoE impacts negatively on sterling.
The pound’s reaction to deficit concerns
Sterling is arguably the market most susceptible to concerns over the government’s debt. When BoE governor Mervyn King recently hinted that further QE might be required, the pound dropped more than a cent against the US dollar in under ten minutes. Yet in the longer-term, concerns over the UK’s credit rating will also weigh on the pound.
What about other major markets?
While fluctuations in the UK currency are strongly tied to fears over the national debt, the picture becomes slightly more complex when looking at other financial markets. Around half the value of the FTSE 100 is contributed by three sectors: oil and gas, basic resources (the mining sector) and banks. Of these, the first two have large-scale exposure to fast-developing, emerging economies with better prospects for growth than the UK or eurozone. As for the banks, HSBC, the sector’s largest constituent, also has extensive exposure to emerging markets. The same is true of its sector-mate, Standard Chartered.
However, while the FTSE is international in scope, there are naturally significant UK-based constituents and lingering doubts about the value of the sterling may dampen investor enthusiasm for UK shares. If an incoming government makes budget cuts too soon, some economists suggest we could see equities test the lows of last year.
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Updated: 25/02/10