Will Budget Cuts Curb Growth?

Government spending cuts sent UK stocks plummeting this week. With further cuts predicted for the new Budget on 22 June, what can investors expect for sterling and the FTSE?

On 24 May, the UK’s Chancellor George Osborne announced a £6.2 billion reduction in public spending – causing sterling to drop from its one-week high of $1.4529 against the US dollar. The next morning, the FTSE 100 sank to an eight-month low of 4,939.

So, what are the the potential effects of the budget cuts on UK markets over the coming months?

A double-edged sword

With the country’s finances in need of attention, sharp cutbacks are being introduced to deal with the crisis. But how are they likely to affect the way investors approach UK-based assets? While limits on spending are good for curbing the country’s debt, they are also likely to be a barrier to growth, slowing the pace of recovery and making the UK less attractive to investors. In the short term, this lack of investment capital could see overseas competitors pulling ahead of investment-starved UK companies, weighing on the FTSE and hampering economic recovery.

On the other hand, if the measures being taken now have a satisfactory 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 could well result in renewed strength against the euro as increasingly paranoid investors embrace the pound as a stable alternative while the eurozone weathers the twin storms of debt problems and economic turf wars.

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. Just 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 5095.78, 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

It’s also vital to look at such issues in a wider context. The announcement of spending cuts may have contributed to the FTSE's Monday morning dip, but at the same time the worry caused by the Spanish banking crisis was dominating investor behaviours and shaking their faith in European assets. The same day also saw the FTSE weighed down by the effects of the Gulf of Mexico oil spill, as the share prices of BP and BHP Billiton sank, dragging the index downwards in their wake.

As such, it’s important to remember that while domestic concerns remain important, global factors can have a far greater effect. 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 concern the rest of the world.

In the face of ongoing global uncertainty, the impact of the UK Government’s spending cuts shouldn’t be discounted; the effect on market sentiment alone could have a marked effect on the UK’s future prospects. But investors may want to consider the risk of overreacting to what is simply an individual factor among many.

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Updated: 27/05/10