George Osbourne to Have Done Enough To Keep UK’s AAA Credit Rating?

UK PMI services posted a disappointing read printing at 50.2 versus 51.1 eyed as they just managed to remain in expansionary mode. This was the weakest result in nearly two years, confirming the thesis that UK economy continues to flatline. Cable saw little reaction to the news as all eyes was on George Osborne’s speech later. The British pound is proving to be extremely resilient in the face of weaker service sector activity and cautionary comments from U.K. Chancellor Osborne who delivered his Autumn statement this morning. The Chancellor announced major cuts to the government’s GDP growth forecasts. They now expect the economy to contract by 0.1% in 2012, versus a forecast for 0.8% growth back in March. For 2013, they expect 1.2% growth in 2013 versus a prior forecast for 2% growth. While the Chancellor stated that, “it is taking time but the economy is healing,” it is clear that they believe the outlook is grim. A number of other changes were also announced including higher taxes on the wealthy, corporation tax cuts, benefit caps and the removal of the 50-year maturity cap on Gilts.

Yesterday’s Autumn Statement was always going to be a delicate balancing act. Going into the Statement, the Chancellor needed to find £17bn of additional savings to keep his fiscal mandates on track. The big question was whether he would seek to find these savings through additional austerity or err towards supporting economic recovery, at least over the short term. In the event, concerns over growth trumped fiscal restraint. He stopped well short of finding £17bn, announcing additional net revenues of £6.5bn by 2017-18, with most of the tightening back-loaded.

Indeed, over the next couple of years the net fiscal stance is projected to be slightly less austere than announced in the Budget, with the sale of 4G spectrum licences and further cuts in departmental spending used to help finance a £5.3bn capital spending package and a host of other small measures designed to support growth and enterprise. The Statement was an implicit acknowledgement by the Chancellor that he supports fiscal austerity – but not at any cost.

After taking into account the announced measures and the sharp downward revisions to the growth outlook, public sector borrowing over the next five years is projected by the Office of Budget Responsibility (OBR) to be £79bn higher than in March. Had it not been for the reclassification within the government’s balance sheet of the coupon payments from the QE programme and the Bradford & Bingley and Northern Rock’s income, the net overshoot would have been greater, at £100bn.

Nevertheless, the Chancellor was still able to announce that the government’s fiscal mandate to bring the cyclically-adjusted current account into surplus by 2015-2016 would be met. But the supplementary target, to have net debt as a share of economy falling, has been pushed out a further year, to 2016-17.

Whether or not today’s fiscal projections will stand the test of time will crucially depend on how the economy evolves. In this regard, the economic assumptions underpinning the fiscal finances look more reasonable.

In summary, the Chancellor was faced with a very difficult choice, but his decision to limit further austerity seems a justifiable response given the current global economic climate. With much of the Statement widely anticipated, there has been little reaction in the financial markets. Lloyds TSB suspect the Chancellor has done enough not to prompt one from the rating agencies either.

The MPC is expected to keep interest rates and QE on hold again today. Although the Governor has indicated that the door has been left open for further stimulus, the improvement in risk sentiment, firmer broad money growth and the desire to await clearer indications of the impact of the FLS argue for no change for now. The Committee will no doubt discuss the implications of the changes in the fiscal stance for the economy and monetary policy, as well as the conclusions of the latest FPC meeting. However, given the ongoing challenges facing the UK, further stimulus remains possible next year. UK trade data is expected to show a wider trade deficit this morning, although it is unlikely to affect markets ahead of the MPC decision. Lloyds TSB expect a global deficit of -£8.9bn from £-8.4bn last month.

EZ Final PMI reading showed a marked improvement rising to their best levels in more than three months helping to keep risk FX bid in early morning European trade. The EZ combined PMI was upwardly revised to 46.7 from 45.7 with German Services PMI rising to 49.7 – just shy of the 50 boom/bust level.

The PMI data shows that economic activity in the Eurozone remains in contractionary territory but if off its lowest levels of the year suggesting that the worst of the sovereign debt crisis may be over. European monetary union has been wrecked by the chronic sovereign debt problems that have forced draconian austerity measures on many of its periphery member nations which in turn has weighed on both investor sentiment and aggregate demand, as slowdown spread from periphery to the core.

However, the latest improvement in periphery yields and the rebound in EURCHF which is now trading above the 1.2150 level indicate that the threat of default risk is now receding and that may ease the credit conditions in the region helping Europe recover in H1 of next year.

EUR/USD fell back a little on weaker Spanish auction results yesterday, but EUR/USD should be well supported in the mid 1.30s today provided that the ECB refrains from any change in policy, as Lloyds TSB expect they will. In practice, the option of a cut in the refi rate seems unattractive as it would have little impact on market rates and would narrow the corridor unless the deposit rate was cut below zero – a step that we think the ECB is reluctant to take. The press conference is likely to hear more about how the ECB stand ready with the OMT, and this is their preferred method of further easing, but of course cannot be activated without an application (from Spain).

Better than expected U.S. economic data and a strong rally in equities led to a divergent performance in the U.S. dollar. The greenback traded higher against the euro, Japanese Yen and Australian dollar but weakened against the New Zealand dollar and ended the day unchanged against other major currencies. According to the ISM report, service activity accelerated in the month of November as the ISM index increased to 54.7 from 54.2. Although the employment component of the report fell sharply, signalling slower job growth in November, the increase in service sector activity suggests that Hurricane Sandy did not hit the economy as hard as some may have feared. Business activity surged thanks to stronger demand for autos and record Black Friday / Cyber Monday sales. Manufacturing activity also beat expectations with factory orders rising 0.8% against a forecast for flat growth. According to payroll provider ADP, U.S. companies added 118k workers to their payrolls last month. While this increase was less than expected, above 100k payroll growth is not bad considering the factors that could have curtailed hiring including Hurricane Sandy effects, President Obama’s policies and Fiscal Cliff concerns. Overall today’s reports will ease some concerns about an abysmally weak non-farm payrolls report on Friday and the continuation of weak job growth thereafter. There are 2 U.S. labour market reports scheduled for release on Thursday – Challenger Job Cuts and Jobless Claims. While the Challenger report is a monthly release and jobless claims is weekly, claims have had a greater impact on the dollar and FX flows than the layoff report. Over the past few weeks, Hurricane Sandy has abnormally distorted jobless claims and only now are we finally beginning to see the true state of the labour market. Jobless claims have fallen below 400k but a further decline is necessary to avoid a big reaction to Friday’s non-farm payrolls report. If payrolls surprise to the downside and claims also decline, economists will point to claims and say that we should have a nice snapback in December.

The contents of this report are for information purposes only. It is not intended as a recommendation to trade or a solicitation for funds. The author(s) cannot be held responsible for any loss or damages arising from any action taken following consideration of this information.

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