IT WAS the most widely predicted event of the year, but it has still set off a host of alarm bells. A one-notch credit downgrade may not in itself have a serious impact on the UK’s credit standing, relative to that of other G20 economies.
But its ability to trigger a potential avalanche of harmful consequences cannot be under-estimated. And that consequence could prove a killer for savers and investors.
A downgrade of the UK’s triple A rating was a given by almost all forecasters back in January. But its timing, with agency Moody’s making its announcement at the end of last week, has proved incendiary. Coming in the middle of a ferocious by-election battle and just weeks ahead of the UK Budget, it is seen to have tipped economic policy into a crisis, put the skids under sterling, put the Osborne chancellorship on a knife-edge and threatened a long-feared bond market sell-off.
Politics has much to do with the near-hysterical coverage the downgrade to AA1 has sparked. This was inevitable, given the repeated pledges that the Prime Minister and the Chancellor had given to defend a top-notch rating currently enjoyed by only three economies and which was in any event not wholly in their gift to control.
But it has also served as a reminder of the fragility of our state. The absence thus far of a credible recovery, the continuing pressure on household budgets and the daunting increase in debt and debt interest despite the “austerity” measures have long rendered us vulnerable.
What had helped was that other economies were in as parlous a state, if not worse. The US spent months dangling on the edge of a “fiscal cliff”. Countries in the eurozone saw bond yields rise to stratospheric levels as government debt soared and the eurozone authorities dithered and delayed over what to do. Against this turbulent backcloth, the UK was seen as a “safe haven”.
But that backcloth has changed. America is seen to be coming to grips with its deficit and the economy is beginning to recover. And the eurozone crisis has abated for now, bringing bond yields sharply down. The UK no longer enjoys that relative safe haven status. And shorn of that, market attention inevitably swings to the problematic state of our own finances and an economy unlikely to see any real growth this year. Prospects for the rest of the world have improved. Those for the UK have not.
A sterling slide under way well before the Moody’s downgrading testifies to this change in market perceptions. Back in early January, sterling was trading at $1.62 – near the top of a seemingly becalmed three-year trading range. It has since tumbled by more than 7 per cent, to $1.53. Now the fear is that sterling has another sharp fall ahead. HSBC is sticking to its forecast that the pound will fall to $1.48 by the year-end, and to €0.91 against the euro.
Our view of devaluation has often been ambivalent. We lamented the further evidence of the UK’s global status and prestige, but we comfort ourselves at the prospect of UK exports being more competitive and the fillip this would bring in terms of orders, investment, employment and profits. This was seen to be good for the stock market, as more than half the turnover of FTSE 100 companies is generated overseas. These earnings and profits would now be worth more in sterling terms.
Less well acknowledged have been the downsides. A weak pound drives up the costs in sterling terms of dollar-denominated raw materials and commodities, such as oil. So the prospect of a further slide in sterling – on top of the slide already recorded – should be of acute concern to households already buckling under the price of petrol on the forecourts. A weak pound works through in myriad channels to higher prices on the high streets, adding to the erosion of household spending power.
Measured in terms of the annual rate (currently 2.7 per cent) inflation hardly seems to figure as an economic threat – so long as it is kept at that level and under control. This is the purpose of the Bank of England. It has been set a target to keep inflation at 2 per cent a year. But we know from the Bank governor Sir Mervyn King that inflation is unlikely to hit the target over the next two years. And this follows a prolonged period – 38 successive months, in fact – when the target has been missed.
What is the longer-term consequence of this erosion of money value? Research out today from Bank of Scotland Private Banking shows us how destructive inflation can be for savers and investors. It finds that the value of money has fallen by 67 per cent over the past 30 years. This means that someone would need £3 million today to enjoy the equivalent lifestyle of a person with £1m in 1982.
Over the past 30 years, the purchasing power of money has eroded at an average rate of 3.7 per cent a year. Looking to the future, if retail prices were to rise by 2.8 per cent annually, the value of money would decline by a further 56 per cent over the next 30 years. Someone would need £229 in 2042 to have the same spending power as an individual with £100 today – or nearly £2.3m to enjoy the equivalent lifestyle of a person with £1m today. Safe haven? Quite the opposite, I would say.