View from City Road: Gilts get a subtle improvement

IT WAS designed as a Budget for gilts rather than equities, which is no surprise given the Government's impending funding programme. And, true to form, it provided few reasons for buying shares and some for selling them.

The absence of another interest rate cut, the promise of increased VAT and, above all, a one-off blow to pension funds' dividend income are all reasons for expecting share prices to weaken in the short term.

Advance corporation tax was the biggest surprise, despite heavyweight lobbying, and will dominate investors' thinking. On the one hand companies such as BAT Industries, Pilkington, GKN and Lucas Industries will all benefit.

Some may even be able to maintain dividends that they planned to cut and others may pay more than they would have done without the concession.

There are enough potential beneficiaries to suggest that their upward share price movements will offset any general stock market decline.

On the other hand, pension funds - which own more than 30 per cent of the stock market - will in effect suffer a drop in income from shares as a result of ACT- associated tax changes.

This change sounds technical but will have the effect of reducing the yield on the FTA-All Share index from 4.1 per cent to 3.85 per cent, a fall of more than 6 per cent. This will be the main depressant on share prices today.

In theory at least, the fall in yield will make equities less attractive against gilts by widening the yield gap. And it will fuel the long-running actuarial debate on pension funds' exposure to equities.

Pension funds currently have more than 80 per cent of their assets in shares, which some actuaries say represents too high a concentration of risk. But fund managers argue that equities have outperformed gilts more often than not and look set to do the same in the medium term.

Some fund managers had feared a tax move to make gilts more attractive, as the Government's huge funding programme gets under way. And it looks as if they got it, albeit in a more subtle form than they probably anticipated. The ACT change represents a substantial bill for pension funds on their equity holdings.

Will the tax change have the intended effect? Fund managers sounded no more enamoured of gilts last night than they were before the Chancellor stood up.

They are still awed by a pounds 50bn borrowing requirement and wonder whether Norman Lamont did enough to reduce the structural deficit. Some thought he should have made a start in the year just beginning rather than wait until the following tax year.

Although sterling rose yesterday the effect will not be enough to reduce the attractions of overseas earners, which have been dull stock market performers until coming to life in recent weeks. With the UK recovery still uncertain, companies as BTR, Tomkins and the drinks majors, including Guinness, Allied-Lyons and Grand Metropolitan - boosted by the Chancellor's decision not to raise spirits duties - continue to look attractive as they will be key beneficiaries of sterling's devaluation and the strength of the US economy.

The irony is that the Chancellor's tax change for pension funds could result in fund managers moving money not into gilts but into overseas markets.