Big investors welcome more headroom in UK budget, fret over long-term uncertainties

By Yoruk Bahceli, Dhara Ranasinghe and Nell Mackenzie

LONDON (Reuters) -Big investors on Wednesday broadly welcomed British finance minister Rachel Reeves' tax-raising budget that gives her more leeway to meet her fiscal targets, but they warned it may not be enough if growth falters because tax hikes are due to kick in later.

Reeves delivered a highly anticipated budget that raises taxes and doubles her fiscal margin, known as headroom, to meet Britain’s fiscal targets, exceeding market expectations, even as welfare spending rises.

Following the budget announcement, Vanguard's head of international rates told Reuters he added back to a position favouring British government bonds, known as gilts, after trimming it before the budget, saying the measures would allow the Bank of England to continue cutting rates.

"While it's not a super positive budget ... we have added to positions," said Ales Koutny, head of international rates at Vanguard, which manages roughly $11 trillion in assets.

Allianz Global Investors maintained a bullish stance, though it had reduced that position pre-budget.

But fund managers at Franklin Templeton, Northern Trust Asset Management, BlueBay Asset Management and Fidelity International said they remained cautious on gilts.

While they said the larger fiscal margin is positive, the asset managers cautioned the outcome of the budget is less certain, as Reeves' plans increase spending in the short term while much of the 26 billion pounds in tax hikes take effect later.

If economic growth falls short, tax revenues could be lower than anticipated and spending higher, eroding Reeves' headroom again, the investment managers said.

"With so much of this being back-loaded, we're not going to know the credibility (of the plans) for some time," said Dan Farrell, head of international fixed income at Northern Trust Asset Management, who prefers Spanish and Italian government bonds to British ones.

David Zahn, head of European fixed income at Franklin Templeton, which manages $1.5 trillion in assets, said he expected Reeves would have to raise taxes again next year -- the third year running following 40 billion pounds in increases last year.

"It's a missed opportunity, and she's just chosen to kick the can down the road," Zahn said.

While long-dated gilt yields posted their biggest one-day fall since September on Wednesday, investors said that was driven more by the Britain's debt management office cancelling some bond sales.

Investors said it remained to be seen how Labour lawmakers, who forced a U-turn on welfare cuts over the summer, would react to the budget.

"There will be lingering risks, both from the political and the fiscal side going forward," said Peder Beck-Friis, economist at fixed-income manager PIMCO, which favours five-year gilts.

RBC BlueBay Asset Management's fixed-income Chief Investment Officer Mark Dowding said he would see further yield declines as an opportunity to take a short position.

He recently contributed to a Reform UK affiliated think-tank report calling for spending cuts in case of a gilt crisis.

The budget boosted sterling , which hit its highest level since late October against the dollar, after recent weakness spurred by pre-budget jitters. Vanguard's Koutny said he had taken a more positive position on the pound ahead of the budget and Wednesday's news reinforced that view.

But Mike Riddell, a lead portfolio manager at Fidelity International, said he was bearish on the pound longer term, given expectations of weaker economic growth and more interest rate cuts. However, Wednesday's sterling rally "is perhaps a bit of a green light for the government," he said.

(Reporting by Dhara Ranasinghe, Yoruk Bahceli and Nell Mackenzie; editing by Amanda Coooper and Cynthia Osterman)