Fiscal factor

31 May 2010 8:00 am

After an election campaign that was long on rhetoric and short on detail regarding how best to tackle the UK’s mounting fiscal deficit, it is finally time to get down to business.

Having seen the response of markets to the eurozone sovereign debt crisis, the coalition government will be mindful of the need for a credible response to our own fiscal shortfall.

And so we are soon to be told where the first £6bn of public sector savings will be made this year. Then, on June 22, George Osborne will deliver an emergency Budget to give us further details about the painful cuts and inevitable tax rises that will usher in our new age of austerity.

However, what that Budget must also do is set out policies that can lay the foundations for long-term productivity growth. The private sector may be improving but that can only go so far in cushioning the short to mediumterm economic blow that comes with the necessity for fiscal consolidation.

In the short to medium term, slow growth and low inflation will be the order of the day. In this environment, corporate bonds should still offer value, particularly investment grade credits. I have favoured this asset class for some time now but, with spreads still wide or around long-term average levels, there is potential for further capital appreciation, albeit much less than we saw in 2009.

Unsurprisingly, given the tough economic outlook, I think the defensive sectors look most interesting. I like consumer staples, telecoms, utilities and high quality asset-backed securities.

There are also some interesting opportunities in financials, especially in senior and lower tier two paper.

However, weak growth presents a risk for the highyield asset class as we could see the risk of default increase again. I have been buying protection against this with credit default swaps on a basket of European companies but, as is often the case in this asset class, name selection will be critical.

The biggest capital gains are well past us and valuations are now closer to fair in this market.

While the new issue market is expected to deliver a lot of new investment opportunities through the year, the sheer volume of supply may pose a further risk.

There are supply issues to be addressed in the gilts market. I expect to see periods of volatility for some time to come as large supply gets absorbed.

We have seen that, even after the announcement of the eurozone rescue package, markets are still on edge. They have finally woken up to the huge transfer of debt from the private to the public sector that took place during the credit crunch. However, I think any sovereign risk in the UK is more likely to manifest itself in a weaker sterling rather than a sharp sell-off in government markets because low base rates should help support the asset class.

High-quality government bonds may have offered one of the few safe havens during the recent market turmoil but this is not the time to put all of one’s eggs in one basket.

With volatility likely to persist in the coming months, investors will be best served by staying diversified, not just at the asset allocation level but also in terms of the mix of fixed income invest-ment strategies they employ in their portfolios. That is something we always advocate in our funds but it is more important than ever now.

Ian Spreadbury is portfolio manager of the Fidelity strategic bond fund

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