Last week, Standard and Poor's, the rating agency, warned that the UK is at risk of losing its coveted AAA credit rating unless it can get better control of its finances and cut debt. Although it affirmed the UK’s short-term debt is still AAA, it has revised its outlook from stable to negative because it sees the debt burden could approach 100% of GDP and remain near that level in the medium term.
If the UK went the way of Ireland and Spain and suffered a downgrade from AAA it would have a dramatic effect. The cost to the UK Government of servicing its debt would rise as investors demand a higher return to compensate for the increased risk in owning gilts. Higher gilt yields would in turn increase the cost of corporate borrowing, thereby eroding recent efforts to bring down bond yields, which had been hoped would inject much needed cash into the economy. The fear of a downgrade to the UK's credit status has already dampened a recent rally in the value of sterling. An actual downgrade would bring a bigger blow since sterling debt would be seen as less attractive – approximately 35% of all gilts or £215 billion is held by overseas investors. Many other issuers are in the same boat and heading towards a rating cut. Of whom, the United States is one of the most notable, with several respected commentators predicting it will eventually lose AAA status. Of course, if a number of nations lose their top rating, the relative difference from one country to the next will be small, thereby mitigating some of the consequences.
Standard and Poor's comments echo those made by the International Monetary Fund (IMF) earlier this week. The IMF praised the UK for its approach to the recession stating it was “bold and wide ranging”. It balanced these comments by adding that the UK still faced many challenges and that its path to better finances hinged on everything going to plan. In order to improve its chances, the IMF recommended the UK should have more ambitious plans for recovery and to build a broad public consensus on the need for sizeable fiscal adjustment. In other words, the IMF thinks the Government should get the nation to agree to more extreme cuts in public spending and tax rises which are needed to reduce debt.
The US State of California has tried to do just that. Governor Arnold Schwarzenegger has been warning of a $21 billion shortfall in the State’s accounts over the next year and advised voters they need to act now in order to prevent a fiscal disaster. He put together a package of proposals which include tax increases and limits in State spending, but Californian voters said no. So, will the UK public take the same line? Probably, if given the choice, but the reality is whether we like it or not we'll soon be hearing the tax man utter Arnie's famous few words from ‘The Terminator’; "I'll be back". So, get yourself ready.
If negative inflation and low mortgage payments have left you with some extra money, put it to one side for darker times. Make sure you use as much of your ISA allowance as possible and don't dismiss pensions. For the higher-earners pensions are no longer so special, but for the masses who earn less than £100,000 they are still very attractive.
For more information on ISAs, pensions and fund selection, speak to one of our Advisers on 020 7189 9999.