Britain’s Chancellor George Osborne announced $121.5 billion (81 billion pounds) in budget cuts by the coalition government Wednesday, which will affect everything from schools to nuclear submarines.
I recently spent a few weeks in Britain, and most of the talk in the papers, on the telly, and among the more thoughtful and sober patrons in the pubs, was on the coming austerity plan from the new government. All accepted it as foregone conclusion, some thought it long overdue, and others saw it as the beginning of a much larger debate on government programs and spending.
The question for traders on this side of the pond is whether this British austerity creates any trading opportunities. It does, in fact, if you can take a step back and look at the longer-term picture (even if the Street is too busy to realize it at the moment).
So how will the spending cuts impact British bonds, stocks and the pound?
British bonds had already priced in cuts to some extent, and responded favorably. They should continue to do so as the cuts are executed, when the next round of cuts occurs sometime in 2012, and as the inevitable problems in countries like Greece and Portugal continue to plague the euro zone. Over time, however, they will fall as the pound falls (more on that in a minute).
Initially, GDP will take a hit. The Bank of England believes GDP will lose half a percentage point of growth from the cuts. Bollocks! They will lose half a percent for every 1% the government cuts back, so the country will go into another recession by the middle of next year. Corporate profits will take a hit and British stocks will fall.
Traders can play this with put options on the iShares MSCI United Kingdom Index ETF (NYSE: EWU).
The British Ben Bernanke, Governor of the Bank of England Mervyn King, pretty much said, “If the government does its bit, we will do ours.” So despite mixed feelings within the British equivalent of the Federal Open Market Committee, once the economy stutters a bit, King will start up the printing presses to begin quantitative easing.
Don’t forget Britain is the world’s fifth largest exporter of manufactured goods, so a falling pound does help. It also helps because my son goes to school in Britain, and I pay tuition in pounds. So I say, “Go, Mervyn, go!”
Traders can take advantage of the falling pound with puts on the CurrencyShares British Pound Sterling Trust (NYSE: FXB).
Bottom line: Bonds should rally before eventually falling with the pound when King starts printing money. And British equities should fall based on a contracting GDP and the hit foreign equity buyers take from a falling currency. This story will take months to take hold, so longer-term put options on EWU and FXB are the way to go.