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New government seen lifting gloom over UK assets

Source: Reuters - Fri 14th May 2010

The new government's plan to make rapid cuts to public debt is likely to shift investor focus back to the domestic economy, whose surprisingly strong improvement should support UK assets in the medium term.

After weeks of uncertainty that weighed on the pound, government bonds and stocks, the coalition between the Conservatives and the smaller Liberal Democrats started on Wednesday to sketch out its main policy goals.

Markets largely welcomed the coalition deal, with sterling rising above $1.50 and shares gaining ground. Gilt futures outperformed their euro zone counterparts.

Given the air of gloom that overhung UK markets before the election, analysts say the new-found optimism may last.

"It's the best outcome for the FX and gilt markets" said Jeremy Beckwith, chief investment officer of Kleinwort Benson. "There is a bit of recovery coming through this year, which is good news."

The new government's key task is to tackle a record budget deficit running at more than 11 percent of gross domestic product. The coalition plans to cut 6 billion pounds of spending this financial year.

While spending cuts are negative for growth and deflationary, a weaker pound would have a positive economic impact as a significant share of UK company earnings comes from abroad, especially as global growth picked up.

Expectations that the Bank of England will keep interest rates low would also have a positive impact on risky assets.

"We are overweight UK relative to other European markets. The UK has been quite a nice value market for us... It's not a domestic political story that drives UK equity markets. It's really global growth" said Rick Lacaille, chief investment officer at State Street.

Last week, sterling hit a one-year low of $1.4475 while UK stocks fell to a 6-month trough and the spread between UK and German government bond yields hit a 12-year high when it became clear no party had won a majority in parliament.

By the end of last week speculators had increased their bets on a weaker pound, meaning the currency could strengthen as less gloomy investors covered those positions/reversed those bets.

The UK/German spread - a barometer of how worried investors about the UK fiscal outlook -- has since narrowed.


Although somewhat overshadowed by the election uncertainty, data has shown the British economy is recovering.

Industrial output expanded in March at its fastest pace in almost eight years, suggesting first quarter growth was stronger than first estimates of 2 percent. The statistics office said there were signs a weak pound had boosted exports.

Separate data showed house price growth accelerated in April and factory activity grew at its fastest rate in 15 years.

"While earlier cuts in public spending are inevitably going to dampen economic growth, the UK recovery appears to be gathering pace having disappointed many analysts so far" said Azad Zangana, economist at Schroders.

UK government bond yields have been rising since October, partly on the public finances outlook and on political worries.

Citi said 10-year gilt yields, currently at 3.853 percent, could fall further.

Citi's 10-year model for gilt yields sees fair value at about 4.0 percent. It expects the risk premium based on fiscal conditions to fall by about 25 bps if ratings agencies affirm the country's credit outlook.

In an early comment, ratings firm Fitch said the five-year fixed-term parliament agreed by the coalition would help keep it focused on cutting the deficit over the medium term.

Analysts said the next 50 days would be key in winning investor confidence if UK assets were to attract more buyers.

"This government looks set to announce much of its policy agenda within 50 days. This 50-day period will be a testing ground for the prospects of the coalition lasting the full four year parliamentary cycle" Rabobank said in a note to clients.

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