Inflation and stagnating growth are still concerns

Investors largely shrugged off the UK’s credit downgrade by Moody’s Investors Service but fund managers have warned inflation and stagnating economic growth are serious concerns for the country.

The UK’s long-expected loss of its AAA credit rating barely moved bond markets last week, with benchmark 10-year gilt yields falling to 2.08 per cent when trading resumed on Monday and rallied yet further to 1.96 per cent as the week progressed.

Moody’s is the only ratings agency so far to downgrade the UK’s credit status, citing slow economic growth and continuing austerity. It maintained a positive outlook for the country, with a rating of Aa1.

The other leading credit rating agencies Fitch and Standard & Poor’s have the UK on negative watch.

But while commentators were keen to emphasise that the downgrade had already been priced in, they highlighted the need for tangible growth to lift the economy.

“There are serious questions about whether the UK will be able to generate sufficient growth to start paying down its debt,” said Robert Farago, head of asset allocation at Schroders Private Bank.

“Inflation is also a concern – unless growth picks up, the UK could find itself in a stagflationary environment in three or four years down the line.”

The rating reduction, combined with questions over whether the Bank of England will increase its asset purchase programme and diminished fears about the euro, sent sterling to its lowest level against the dollar in two years, falling to $1.51 on Monday. Managers said the loss of the UK’s “safe haven” status was long overdue.

Stephen Bailey, co-manager of the Liontrust Macro Equity Income fund, said before the downgrade investors had “ignored” signs that the pound was struggling.

“It has come as no surprise that Moody’s has stripped the UK of its triple A credit rating, although the execution of this downgrade appears to be rather late in our opinion,” he said.

“Sterling has already fallen in excess of 6 per cent against the dollar during 2013 and the perceived ‘safe haven’ status that was attached to the pound throughout 2012 has now diminished.

“All the negative factors contributing to the recent weakness were present during 2012 and yet the majority of investors and speculators choose to ignore these signals.”

As a result, Mr Bailey said the fund was seeking to derive most of its income from overseas.

Old Mutual Global Strategic Bond manager Stewart Cowley said he had been diversifying out of sterling in the fund for some time to prepare for this eventuality so that “where the fund will benefit most is if the pound falls, inflation expectations rise and conventional gilt prices fall”.

To hedge for inflation, the manager has about 25 per cent of the fund in inflation-linked bonds, and a small position short-selling the conventional gilt market through the sale of futures.

Nigel Sillis, director of research, fixed income and currency at Baring Asset Management, said the firm was also bearish on gilts and US treasuries as there was no obvious catalyst for UK growth on the horizon.