Diverging Opinions: S&P refuses to follow Moody's, instead reaffirming the UK's AAA

A few weeks ago, Moody's downgraded the UK one notch to AA1, depriving it for the first time of its top AAA rating. It was roughly a month before the Chancellor was due to deliver his budget, and we wondered what Moody's knew that we didn't. Well, maybe not a great deal. In a counter move, Standard & Poor's yesterday announced that it would be maintaining the UK's AAA rating, albeit with a negative outlook and a one in three likelihood of downgrade over the next 18 months. The agency expects the UK economy to grow by 1.6% per year for the next three years - below estimates provided by the Office for Budgetary Responsibility. It also states that any easing of the austerity program may precipitate a downgrade. Fitch Inc has altered the UK's status from "negative outlook" to "negative watch", indicating that a downgrade may yet be imminent, but allowing the UK to cling on to the top rating for a little longer.

So why did the largest two ratings agencies come to different conclusions about the UK economy?

I discussed the downgrade by Moody's in a previous post, and will focus on S&P's decision here. 

S&P's reaffirmed the UK rating because “the Government remains committed to implementing its fiscal programme, and has the ability and willingness to respond rapidly to economic challenges”. This is despite the fact that the national debt as a percentage of GDP in 2016 is expected to rise from 85% to 95% while the deficit falls to only 4.2%. While this clearly remains within the 'acceptable' limits of fiscal consolidation according to S&P's, the agency warned that should the pace slow any further, a downgrade will follow. The top rating was apparently spared on the back of the UK's wealthy and diverse economy, the flexibility of fiscal and monetary policy, as well as flexible and adequate product and labour markets. These were taken into account by Moody's as well though, indicating perhaps that S&P's has placed slightly more weight on the willingness and political commitment of the government to stick to its austerity plans, come rain or shine.

Standard & Poor's also made mention of the EU referendum promised to UK voters by David Cameron. The agency's assumptions are based on the premise that corporate sentiments are unaffected by the uncertainty created by the referendum. In other words the CRA acknowledges that the referendum creates uncertainty - that businesses are cautious in uncertain climates - but goes on to conclude that this is not the case here. Why? Much of the literature on investment emphasises the role of certainty and predictability in creating a suitable investment climate to attract businesses and long-term investment. Uncertainty surrounding the future of the UK within the EU, and a potential end or alteration to the free movement of goods, people, services and capital across British borders within the European Union could seriously harm the UK.plc's outlook. Not that there is much Mr. Cameron can do about this now, having made the promise to the electorate. S&P's does state that should it's assumptions about business here prove wide of the mark - and investment does suffer as a result of uncertainties - a downgrade could follow.

Oddly enough, having chronicled this, the next question is 'does it matter'? Well, in short, not really. Even the downgrade by Moody's had been factored in by the markets prior to its announcement, and the expectation that S&P's and Fitch will follow suit is widely assumed. Will it cause markets to reappraise their levels of risk associated with UK bonds, now the AAA has been confirmed? Unlikely. Besides, the AAA rating is becoming an increasingly rare specimen these days. The stigma of suffering a downgrade has been severely diluted by the sheer quantity of downgrades that have taken place over the past few years. 

But this state of affairs does lead to another - perhaps more important - question. If the markets are regularly factoring in risk assessments to their operations weeks (usually) before any announcement on downgrades by the CRAs, and if the impact of a downgrade has been reduced to the extent that sovereigns are no longer worried by an announcement, are we witnessing the slow demise of the role of CRAs in international markets? 

It's Finally Happened - Moody's Downgrades the UK

Moody's finally confirmed market rumours this evening and downgraded the UK's government bond rating from AAA to AA1. It cited several factors, including the sluggish growth outlook for medium-long term, anticipating that weak growth will last into the second half of the decade, posing challenges for the government's fiscal consolidation programme. The consequences of this include the government's "high and rising debt burden" which reduces the capacity for shock absorption on the government's balance sheets. Importantly, because of the extended time frame of the fiscal consolidation plans, taking them into the next parliament, the level of risk involved has increased. Now, instead of peaking in 2014, Moody's expects the UK's gross general debt to GDP to peak in 2016 at 96 per cent, which is up from just over 90 per cent now.

Despite these problems, Moody's stresses that the UK still retains high creditworthiness, due to its competitive, well-diversified economy, previous and future fiscal consolidation and robust institutional structure. It's favourable debt structures, bond maturity lengths, and the resulting reduced interest rate risk on UK debt are all additional factors in the UK's favour. Moody's seems to believe that the government's fiscal consolidation plan will, in time, be fulfilled, given the UK's underlying economic strengths. The ratings agency does mention that the UK's exposure to the Eurozone is an issue that may become more urgent depending on how the crisis in that area progresses, however the contagion is stated to be mitigated by the UK's independent monetary policy and the status of sterling as a global reserve currency.

Moody's had changed the outlook from stable to negative in February 2012, however today's downgrade shifts the outlook back to stable. Speaking this evening in response to the downgrade, UK Chancellor of the Exchequer George Osborne took the news as a "stark reminder" of the troubles being faced by Britain, and vowed to "redouble" his efforts to reduce the deficit and maintain historically low interest rates for families. Interestingly, the downgrade comes less than a month ahead of the Chancellor's budget on March 20th in which he will outline fiscal policy for the coming months. 

But will the downgrade actually make any real difference? 

The short answer to this is, well, economically no, but politically, maybe. For a start, bond markets are usually a couple of months ahead of ratings agencies when it comes to anticipating difficulties and slow growth prospects, and sterling has fallen significantly against the dollar over the past few months. This has the advantage of making exports cheaper, helping the UK economy, but it tends to signal that all is not well for economic outlooks (regardless of rumours of currency wars). More to the point, rumours have been circulating for some weeks - some even publicly - that the UK is on the verge of a downgrade. The announcement tonight by Moody's should not have surprised anyone. Will bond yields increase dramatically when the markets open on Monday morning? Unlikely. And considering the role call of countries who have been downgraded over the past few years, the UK is simply the latest to join the list.

But the political issue is slightly trickier. Like other political leaders across the western world, Osborne staked a good deal of political capital on maintaining the AAA rating. I recently posted about the French reaction to their downgrade from AAA. But it's loss in the UK may prove to be a double-edged sword. While it may force reappraisal of fiscal policy, it might also give the Chancellor some room to breathe and reassess his options.

Undoubtedly it marks a recognition by a CRA that the deficit reduction plan is not working as successfully as planned, and that plans for growth haven't produced the desired results. Fiscal policy to get Britain moving after the recession focused around shifting from domestic consumption to an export-oriented base. But as nearly 40 per cent of UK exports are destined for Europe, the ongoing recessions there are less than encouraging. You simply cannot build growth by exporting to contracting economies. The good news is that the markets still appear to have faith in the political and economic ambitions of the UK government. Bond yields remain persistently low, despite some warning of a collapse in the bond markets as seen by Greece. The economic reputation of the UK remains intact, but questions are likely to be asked over the coming days about the political will to stick to austerity, especially given the backlash against pure austerity in other parts of the world, notably Japan and France. It will be interesting to see, therefore, if the Chancellor's "plan A" will be "tweaked" slightly to take account of the latest developments, and shift slightly away from austerity towards growth.