Darling's Wishful Thinking Budget is Bad News for Gilts

By: MoneyWeek

Rats are usually the first to abandon a sinking ship. But in Britain, it seems the rats are only too happy to stick around. According to Bloomberg, rats are "thriving, with shuttered shops and half-built housing sites to live in, rotting piles of uncollected garbage for dinner, and fewer exterminators sent out to kill them." The rat population has grown by 13% this year, to more than 50m, reckons Peter Crowden, head of the National Pest Technicians Association.

It just goes to show that there's always a bright side for somebody, no matter how bleak things look. It's just a shame that in the case of Britain's slump, it's pretty much limited to the vermin...

The real reason the Budget was so bad

Britain's GDP fell by 1.9% during the first quarter, worse than the 1.5% expected. It also means that Alistair Darling's prediction of a 3.5% decline this year already looks over-optimistic – the year-on-year fall is already at 4.1%.

As Ian Campbell points out on Breakingviews.com, while the Chancellor was at pains in his Budget to emphasise the problems the rest of the world is having, "he didn't mention that among the major economies only three have budget deficits soaring into double-digit proportions of GDP: Ireland, the US and the UK."

We know what's happened to Ireland. The country has been forced to slash spending and hike taxes. "The US and UK are now alone in taking their deficits to extremes in huge government gambles on a swift, strong growth revival."

The real problem the Government has is not so much the big deficit. Big deficits can be affordable assuming that people believe you can pay it back. And as a developed world country, the UK gets cut a lot more slack than somewhere like Argentina, for example.

The real problem is if investors start to lose confidence in your ability – or willingness – to repay the debt. And that's the real reason that the Budget was so bad. As Edward Hadas puts it, also on Breakingviews.com, Britain just doesn't 'feel' like a good credit risk. "Suppose a triple-A rated company suddenly found that expenses were running at 123% of revenues. Such a huge loss would cause a financial red alert. Cut back spending, push up revenues, figure out what's going wrong and prepare for even worse times."

But instead of tackling Britain's economic problems, the Chancellor seems to be wishing they'll just go away, with his prediction of a sharp rebound in the economy come 2011, and no real intention of making any serious cuts to public spending.

In the meantime, his purely politically motivated attack on those earning six-figure salaries, will make the UK a less attractive place for entrepreneurs to relocate (and may result in existing ones upping sticks and leaving, though I suspect most will wait until the next election is over before actually emigrating).

The more the Government is seen to be messing around at the edges and shying away from getting to grips with the debt, the less keen investors will be to support its spending. That would push up gilt yields, and hit prices. The same would happen if the Government prefers to inflate its way out of debt, rather than cut spending and raise taxes – another very possible scenario. It all adds up to yet more reasons to avoid conventional gilts.

Why big pharma looks good now

If you are looking for a solid income option, then here's a suggestion for you from today's other big story. The Telegraph reckons that the outbreaks of swine flu in Mexico and the US could help boost the share price of pharmaceutical stocks. Both Roche and GlaxoSmithKline have said that they may need to supply "millions of vaccine doses" to protect against the virus, the newspaper says.

Indeed, Bloomberg reports this morning that sales to governments of Glaxo's Relenza flu drug were higher than sales of Roche's Tamiflu for the first time last quarter, as countries seek a wider range of stockpiled medicines "to protect against a pandemic". Glaxo expects the trend to continue.

I don't think you should buy pharma stocks to profit from this. It seems likely (fingers crossed) that this story will end up going the way of fears about bird flu a couple of years ago – some frightening headlines, then the story goes back into hibernation until the next big outbreak.

But I'd be happy to buy big pharma at these levels regardless of the headlines. Glaxo (LON:GSK) currently yields around 5.5%, while as MoneyWeek regular columnist James Ferguson points out in his Model Investor newsletter, AstraZeneca (LON:AZN) is also looking cheap, yielding 5.4%. If you're looking for solid stocks providing decent income, there can't be many more attractive sectors out there right now. I'd certainly feel more comfortable holding these companies than buying gilts.

By John Stepek for Money Morning , the free daily investment email from MoneyWeek magazine .

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