U.K. General Election result should drive direction of the Pound

This morning there was an interesting debate on CNBC after the future direction of the British Pound versus the Euro. The Euro has been under pressure over the last few weeks as Ireland, Portugal, Spain and particularly Greece struggle with huge budget deficits and sharply declining GDP’s.

If the Bank of England decides to maintain rates at 0.5% despite the worrying inflation numbers released for December, the pound could come under pressure as other economies raise interest rates faster as their growth recovers faster. This is already happening in Australia and although the U.S. Federal Reserve seems to be reluctant to raise interest rates in 2010, 2011 may be a different scenario particularly if U.S. treasury auctions to fund the huge budget deficit start to become difficult.

Both the Labour government and the Conservative opposition in the U.K. acknowledge the current budget deficit needs to be tackled but detail on is scant as the Election looms this summer. VAT moved back to 17.5% from 15% in January and several tax increases are due to hit in the next financial year starting April but the deficit remains a significant concern for the U.K. economy. The issue of government debt (Gilts) to fund this budget deficit has been supported by the Bank of England’s Quantitative Easing (QE) programme, but this will come to an end this year. In Q3 2009, the Bank of England bought some £97 billion in Gilts as part of QE.

The risk is that this Summer’s General Election will produce a Hung parliament where no party has an overall majority and this will slow down efforts to bring down the deficit. If this happens there will be a double whammy as Gilts continue to be issued and QE slows down to soak up the issue of this debt. The price of Treasury’s will fall as demand drops for these securities and the yield will rise. If the deficit is not dealt with quickly, there is a risk of Credit Rating Agency downgrade, reducing the U.K., triple A rating which again would push Treasury’s lower and the pound. A clear Conservative party win should reassure investors and drive Sterling and government debt prices higher. Therefore the future direction of the Pound seems linked not only to the future movements in Interest rates but are intrinsically linked to the Election. Uncertainty spooks investors, and a party without a clear electoral mandate through a majority in Parliament may be bad news for investors in Sterling.

Cadbury - Buffett expresses doubts on takeover price

Yesterday, Kraft Foods (KFT) of the U.S. increased its bid for the UK confectioner Cadbury (CBRY) to £5 per share in cash and 0.1874 Kraft shares for each Cadbury share (up from its previous offer of £3 per share in cash and 0.2589 Kraft share for each Cadbury share). The deal values Cadbury at a 13 times 2009 earnings. Last night Warren Buffett, a major shareholder in Kraft, said that the company had over paid for the acquisition to proceed with the share price having almost doubled since the bid (closing yesterday at £8.34) was announced and valued the company at £11.5 billion.

The combined firm will overtake Mars/Wrigley to operate as the leading player in the global confectionery market but with margins under pressure as the price of raw materials continues to rise, U.K. workers union fears that that Kraft may take an axe to the Cadbury organisation to aggressively cut costs may be the key driver to deliver a return on this investment.

With Buffett, expressing his reservations about the deal, Kraft management have a lot to prove. As the history of these type of high premium takeovers shows, shareholders are often disappointed. Let’s see if Kraft management follow the trend.