SPECIAL INVESTMENT BULLETIN

SPECIAL INVESTMENT BULLETIN

Reaction to the
Comprehensive Spending Review
Introduction
Back in June, the Chancellor George Osborne set out plans to fill a £149bn budget deficit by 2014/15 through
a combination of tax increases and spending cuts. The bias was firmly towards cuts: tax was only meant to fill
23% of the financial black hole, with the other 77% to come from wielding the axe on Government expenditure.
Last Wednesday (20 October), Mr Osborne delivered his long-awaited Comprehensive Spending Review (CSR)
of public sector finances. As was widely expected, this announcement detailed £81bn of spending cuts over the
next four years; the largest real reduction in state spending in modern times.
With health, overseas aid and parts of the education budgets protected, it was widely interpreted as implying
across-the-board cuts of 25% for those ‘unprotected’ departments. As it emerged, the departmental cuts
averaged 19% (source: Technical Connections), mainly due to the substantial reductions of £7bn made to welfare
benefits and tax credits.
The key challenge will be to deliver these cuts without risking a sharp slowdown in economic growth and a
return to the recession of 2008/9. As Anatole Kaletsky writing in The Times (21 October) suggested, “Whether
the coalition’s radicalism is remembered by history as visionary and courageous or recklessly self-destructive is a
question that nobody will be able to answer until the end of this Parliament and perhaps beyond.”

Reaction
Stock market reaction to the publication of the detail behind Mr Osborne’s plan was spectacularly muted. The
consensus view held by most was that, barring a significant backtrack or, worse still, the instigation of a more
overzealous approach, markets had generally ‘priced in’ the effect of the CSR. And whilst it will take years rather
than weeks or months for the full details to emerge of how these spending cuts have manifested themselves, there
is a certain sense that we now have a platform from which to move forward.
Adrian Frost of Artemis Investment Management, joint manager of the UK & International Income Fund stated,
“Whilst we know the quantum and shape of the CSR, much of the detail and timing has yet to be determined.
There were few real surprises; we had been given fair warning of the scale of the cuts and if anything they were
slightly less draconian than some had feared. In our view the market has had long enough to worry about this
issue and the affected sectors and shares have largely discounted the review.” This view was echoed by Stuart
Mitchell of S.W. Mitchell Capital, “The Chancellor’s spending review contained little to surprise, outlining a
range of more-or-less widely expected spending cuts. That these will have a dampening influence on activity is
therefore scarcely news.”

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Moreover, the need for swift, decisive action has been met with general agreement by most commentators.
Further procrastination, with the lack of a solution to reduce the Government’s ever-growing debts, seems
an equally unpalatable option. “The cuts were almost certainly necessary in order to reduce the budget deficit
and ultimately restore the health of the UK economy. In the long term, this should help UK consumer-facing
businesses and financials as it hopefully reduces the chance of much higher interest rates at a later date,” observed
Nick Purves of RWC Partners.
In the short term the CSR does present further issues for a number of the more cyclical sectors, “There is no
doubt in my mind that the economic outlook remains challenging. Credit growth [lending] is largely absent,
banks continue to repair their balance sheets and consumers remain intent on rebuilding their finances following
a prolonged period of debt-fuelled spending,” said Neil Woodford of Invesco Perpetual.
Zak Summerscale of Babson Capital added, “We remain cautious over our exposure to sectors like UK retail, and
will continue to selectively invest in assets with prudent capital structures and ample liquidity that will enable
them to comfortably absorb any slow down in the UK economic growth rates.”
The impact on consumer-facing sectors is a theme further considered by Ian McVeigh of Jupiter Asset Management,
“The key for our portfolio is the effects the review has on UK consumer spending. This is harder to assess.
Expectations are not high to start with and our consumer positions reflect a belief that with low valuations,
modest positive surprises could lead to strong share price moves from a basis of low expectation.”
The impact of the spending cuts will no doubt be felt hardest by the 490,000 public sector employees who will
be forced to seek alternative employment as a result of the CSR. Whilst improvements to the efficiency of the
Government ‘machine’ are to be welcomed, this will present significant loss and heartache for those affected
first-hand. That said, as the economy continues on its slow and difficult path to recovery, there are signs that
sustained, structural unemployment over the long term may not prove to be the reality. “We note that the
private sector employs 4 times as many as the state sector and the private sector has, this year, been adding jobs
at a rate that will more than offset the job losses among public sector employees,” added McVeigh.
It has also been observed that whilst spending cuts imply a further slow down for the economy, there are those
sectors and businesses that stand to benefit from a change to the previous regime. John Innes of RWC Partners
commented, “The CSR should be seen as part of a positive reallocation of resources away from the less productive
to the more productive areas of the economy. Cutting welfare whilst maintaining spending in education and
infrastructure should be seen as good for the UK private sector, particularly the outsourcing sector which should
continue to prosper.”
John Wood of JO Hambro shares this opinion, highlighting that, whilst some areas will see an increase in their
budget between now and 2014/15, outsourcing is an area that offers potential over the medium to long term,
“Most of the nominal growth comes from [inflation-linked] welfare and health spending so there is a significant
absolute fall in capital expenditure, and a very tight focus on administrative efficiency both centrally and at
the local level. Every single department is to cut its admin costs by a third. In time we still believe there is an
important role for private sector companies to play in formalising delivery against these objectives, however, it
will take a while for cultures to evolve and contracts to be awarded. In that sense the announcement is more a
beginning than an end and we await further detail.”

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Outlook
The UK is not alone in delivering a package of austerity measures, with many of the world’s most powerful nations
undertaking a similar review with the single objective of creating a flexible, sustainable economic platform.
Stuart Mitchell offered this view of how these measures will impact the UK marketplace, “The important, but
often rather arid, argument about the extent to which fiscal austerity will or will not stifle an extension of this
revival is therefore only secondary in considering the future course of equity valuations in the UK. With little
prospect of any sustained campaign by the Bank of England to drive interest rates higher, company management
is likely to continue with its tight control of costs, thereby permitting a further extension of the powerful
margin improvements seen to date. Investor expectations for future profits are, as a consequence, still probably
too cautious.”
Nick Purves added a similar point on the valuation of UK companies, “For the moment, investors seem to be
focussing on the near-term impact on consumer spending and unemployment, which explains why many UK
domestic businesses are being priced so lowly in the stock market and conversely why those with exposure to
fast-growing Asian markets are priced so highly.” Consideration of Western markets’ historic dependability
and the need to adopt a long-term view is one echoed, once again, by Neil Woodford, one of the UK’s most
successful investors over the past 25 years, “In time, I believe companies with dependable characteristics will be
valued more sensibly. A valuation premium for dependability is normal and justified. In difficult economic times,
the quality premium deserves to be even bigger than usual and I strongly believe that, ultimately, the premium
will be restored. Patience is required, but in the meantime, the combination of dividend yield and dividend
growth from dependable growth companies should result in very satisfactory returns for investors.”
Whilst the impact for the UK market is at the forefront of most investors’ minds, it should be remembered that
the global marketplace is increasingly interwoven. The success of UK companies is not centred solely on business
transacted in the UK and 70% of the profits from FTSE 100 companies are derived from overseas trading
activity (source: Charles Stanley). Each individual market will have its own characteristics and periods of prosperity;
but what is evident from the global ‘belt-tightening’ is an acceptance that the system is broken and that there is
strong commitment to fix it.
So what is the outlook for the global economy? Quite clearly, opinions here are polarised. The success, or
otherwise, of the CSR and similar processes will not be known for some time. What we do know, however, is
that the ultimate intention is to provide a sound footing on which the green shoots of recovery we have witnessed
over the past 18 months can build and flourish.

The information contained herein represents the view and opinions of the individuals
quoted, and not those necessarily held by other investment managers or St. James’s Place
Wealth Management.

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