Government spending cuts sent UK stocks sliding this week. With further cuts predicted for June, what can investors expect for sterling and the FTSE?
On 24 May, Chancellor George Osborne announced £6.2 billion of public spending cuts – causing sterling to plummet from its one-week high of $1.4529 against the US dollar. The following morning saw the FTSE at an eight-month low of 4939.
Let's explore the potential effects of the budget cuts on UK markets over the coming months.
The pain barrier
With the country’s finances in disarray, sharp cutbacks are the new Government’s weapon of choice to deal with the crisis. But how are they likely to affect investors’ attitude to UK-based assets? While a curb on spending is good for mitigating the country’s debt, it is also likely to be a barrier to growth, slowing an already shaky recovery and making the UK less attractive to investors. In the short term, this lack of investment capital could see UK companies treading water while overseas competitors pull ahead, weighing on the FTSE and stalling economic recovery.
On the other hand, if the measures being taken now have the desired effect on the UK’s national debt, the long-term consequences could well be positive. In the case of sterling, any reduction in the UK’s deficit is likely to help the currency strengthen against the euro as increasingly paranoid investors see the pound as a stable alternative to a euro undercut by the debt problems and economic turf wars of the eurozone.
As a case in point, while sterling performed poorly against the US dollar immediately after budget cuts were announced, it simultaneously rose steadily against the euro.
A brief dip in performance
For the FTSE things have been considerably more volatile. A few short weeks after hitting a 21-month high, the index had once more sunk below the 5000 mark, dogged by the ongoing eurozone debt crisis as well as the announced spending cuts.
However, by 27 May the FTSE was back up to 5095, buoyed by unexpected expansion in the latest economic growth figures. This seems to suggest that while budget cuts may have a short, sharp effect on the FTSE, the index is more profoundly affected by solid economic results.
Cuts in context
As ever, it's important to look at such issues in a wider context. While the announcement of spending cuts may have contributed to the FTSE's Monday morning dip, the worry caused by the Spanish banking crisis was dominating investor behaviours and rattling their faith in European assets. The effects of the Gulf of Mexico oil spill were also weighing on some of the industrial sector's heavy hitters, as the share prices of BP and BHP Billiton sank steadily and dragged the index downwards in their wake.
As such, it’s important to bear in mind that while domestic concerns remain important, global factors can have a far greater effect on the UK. It was a mortgage crisis in the US, after all, which was responsible for the 2008 crash and threw the UK into turmoil along with the rest of the world. At present the FTSE’s volatile performance remains closely linked to fears over eurozone stability, while recent economic ripples over the ongoing face-off between North and South Korea have spread beyond Asian markets to the rest of the world.
In the face of this continuing global uncertainty, the impact of the UK Government’s spending cuts shouldn’t be discounted; the effect on market sentiment alone could have a significant effect on the UK’s future prospects. Investors may want to consider, however, the risk of overreacting to what is simply one small cog within an integrated global machine.
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Updated: 27/05/10