Will the Spending Review Cut Too Deep?
The much-anticipated UK spending review was aired on Wednesday 20 October, with Chancellor George Osborne presenting budget cuts totalling £81 billion over the course of the next four years, in an attempt to combat a record £156 billion deficit.
The deficit reached 11% of GDP this year, and Mr Osborne believes that the only sure way to nurse the economy back to recovery is to reduce this deficit down to 2% by 2015. As many as 490,000 public sector jobs are likely to be lost along the way, alongside an average reduction of 19% in departmental budgets.
So what could these significant cuts mean for the domestic economy?
Gentle recovery or harsh decline?
Spending cuts on this scale are always going to have an effect on economic growth. The new Office for Budget Responsibility predicts growth of just 1.2% this year, increasing to a slightly better 2.3% in 2011. While these numbers seem and in fact are meagre, they still represent forward progress, and are in line with Government expectations.
However, opponents of the cuts believe that austerity measures of this magnitude could put the economy in reverse and lead the UK towards a dreaded 'double dip' recession.
When Mr Osborne announced budget cuts previously, in May this year, sterling took an immediate hit against the dollar, and the following morning the FTSE® 100 plummeted to an eight-month low of 4939. It has taken the UK's leading index until mid-October to recover to pre-May levels. Will we see a similar reaction this time around and, if so, will the FTSE® be able to recover from them?
How will the FTSE® 100 be affected?
Investors have been expecting these cuts for several months, and so in theory their effects should be priced into the market already. The early reaction appears to support this view, with the FTSE® 100 trading relatively flat on Wednesday afternoon. There remains the possibility and opportunity for volatility over the coming days, weeks and months however, as investors begin to speculate on the Bank of England’s reaction to the measures.
The BoE’s stance is very much up in the air at the moment, judging by the minutes from the Monetary Policy Committee’s October meeting, where a three way split announced a degree of uncertainty. In the meeting one member called for further quantitative easing to be introduced, another recommended an interest rate increase, and the remaining seven voted for no change to the now customary 0.5% rate.
If Mr Osborne’s cuts are deemed to be damaging growth too much, then further monetary stimulus could well enter the equation, potentially providing a boost for equities. However, if inflation is regarded as the main issue, then we might have an interest rate hike on the cards, which could have a negative knock-on effect for UK stocks.
Will sterling take a pounding?
The review’s implications for sterling are complex. If these heavy budget cuts do reduce the deficit as Mr Osbourne hopes, sterling could strengthen as a result. However, if the cuts are too deep the potential for a double-dip recession and/or more quantitative easing from the BoE increases, both of which would hurt the pound.
Again it’s monetary policy that could be key. If investors catch wind of further government stimulus, the pound could well follow the dollar south, but if the budget cuts are regarded as a successful means of reducing the deficit, we could see sterling regain some of the ground it lost just prior to the review.
Take a position
Whether you see the UK economy clinging onto its hard-won recovery or sliding back towards recession, with IG Markets you can back your judgement on a range of financial markets.
We offer a one-point spread on the FTSE® 100 and competitive prices on all other major global indices, as well as on individual shares and commodities. You can also trade CFDs on a wide range of major and exotic forex pairs.
If you are not already an IG Markets client you can apply online and open an account in minutes to start trading.
Updated: 25/10/10
The above comments do not constitute investment advice and IG Markets accepts no responsibility for any use that may be made of them.
SHARE: