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A billion here, a billion there, and soon it all adds up

Headlines show how different newspaper, think tanks and economists summarise today’s Budget statement. “Sunak adds £65bn of support as OBR cuts growth forecast; UK Budget offers solid support for spring recovery; Sunak gives economy a shot in the arm, but long-term condiIons sIll bleak; Industry reacts to Sunak’s fiscal ice age; Time to start plugging the pandemic-shaped hole”.

How should the financial markets interpret the Chancellor’s statement? At the start of the day, sterling/dollar was 1.395 and the 10-year gilt yield was 0.69%, while the FTSE100 index closed yesterday at 6613. At the close of play today, they were modestly different (1.40, 0.77% and 6668 respecIvely) although this was also a day when US bond yields moved higher on inflaIon worries.

Markets decided to focus on the growth signals from the Chancellor. There was lible in the statement to concern the Bank of England in the near term. Fiscal policy will help sustain economic acIvity in 2021 and 2022. The danger period will come towards the middle of the decade – is the recovery as strong as hoped for? How does that ripple through to inflaIon? Do the public sector’s finances need more or less support?

The Treasury is necessarily keeping its wallet open in the coming year in view of the impact of the lockdown on the UK economy. The Chancellor has been generous with a blizzard of spending announcements – furlough extended to the autumn, another package of support for the arts and the high street etc. CumulaIvely they add up to £44 billion or 2% of GDP. This comes on top of the government’s support for the economy since the pandemic began to the tune of £280 billion.

The key issue which the markets wished to understand was how this largesse would be paid for. What are the prospects for future growth in the economy, what is the mixture of spending cuts, and/ or borrowing from future generaIons, and/or tax increases, and if so on labour or capital or property, which would be indicated in the speech?

Investors will take different views about the UK’s economic prospects depending on their Imeframe. Ajer GDP collapsed 10% in 2020, the OBR’s expectaIon is for growth of 4% in 2021 and 7.3% in 2022, meaning that the economy is forecast to return to pre-Covid levels by the middle of next year. This partly reflects the easing of public health restricIons allowing many households and businesses to spend the savings built up during the recession. In addiIon the Treasury is pinning its hopes on a temporary tax break cosIng more than £12 billion a year to encourage businesses to bring forward investment spending from the future into this year and next.

It should be noted, however, that a forecast of 4% GDP growth in 2021 is sharply lower than the expectaIon of 5.5% made as recently as last November. Another difficult issue for the Chancellor is that even ajer two years of strong economic expansion, the OBR expects that business acIvity will then subside; ajer growth of 4% in 2021 and 7.3% in 2022 the GDP esImates are only 1.7%, 1.6% and 1.7% in the following three years. In other words the combinaIon of Brexit trade barriers and the scarring effects of the pandemic are expected to reduce trend rates of growth in the UK to under 2% from around 2.25-2.5% a few years ago. In due course this will necessarily feed into Bank of England thinking.

Another issue for gilt investors concerns the amount of debt issuance which markets need to digest, assuming it is not all purchased by the Bank of England. The outcome is bleak. The budget deficit is expected to come in at about £355 billion in the financial year 2020-21, deceleraIng to £234 billion in 2021-22, then £107 billion and £74 billion in subsequent years. These esImates are somewhat higher than had been expected; a Reuters poll of primary dealers carried out before the Budget had


forecast total gilt issuance would be around £260 billion in the coming financial year, comprising a budget deficit around £180 billion alongside £80 billion of gilts that will mature and need rolling over.

The IFS and other think tanks had warned that there was a need for further tax increases and spending cuts in order to stabilise public sector finances. The Chancellor put forward a down payment, with tax increases worth about £25 billion by 2025. However, that mainly appears in later years through the delayed rise in corporaIon tax and the slow but inexorable effects of fiscal drag through freezing various income tax and pension allowances. This Budget will increase the tax burden from 34% to 35% of GDP in 2025-26, its highest level since Roy Jenkins was Chancellor in the late 1960s. While public spending is set to be 2% higher as a share of GDP in 2025-26 than in 2019-20, this mainly represents higher spending on a few areas, health, educaIon and public investment, leaving lible room for manoeuvre in many other areas. The long-term scarring effects of the pandemic on the economy’s potenIal are starIng to be seen. Indeed, many of the government’s difficult decisions have been delayed. Most notably, the ‘super-deducIon’ for business investment is set to expire just as business taxes start to rise in two years’ Ime. The 2023 Budget could be rather difficult if the UK economy has not recovered as well as the Chancellor hopes!

Despite strong economic growth for at least two years, some tax increases and further spending restraint, the debt burden looks set to remain large over the coming decade. While the UK’s public debt remains close to 100% of naIonal income throughout this period, the current low level of interest rates means that the costs of servicing falls to a historic low of just 2.4% of total revenues. A future threat, therefore, is a sharp rise in inflaIon expectaIons, in the UK or elsewhere, resulIng in higher gilt yields. As the OBR warns, the rise of 0.3% in interest rates that has happened since it closed its forecast on 5 February would already add a further £6 billion to the interest bill in 2025-26.

As ever with Budget statements, the devil will be in the detail. The Chancellor made a surprise announcement that he would update monetary policy for Bank of England to reaffirm its 2% inflaIon while ensuring support for the net zero transiIon so environmental, social, and governance consideraIons are core to its remit. What this means in pracIce remains to be seen.

Last but not least, all the figures in this note should be treated with cauIon. They are best esImates by the OBR and the Treasury at a moment in Ime, with considerable uncertainty. To give just one example, the OBR has warned that in a downside scenario the UK economy might only regain its pre- pandemic levels at the end of 2024, rather than mid 2022 as it currently suggests. The world could look very different by the Ime the Chancellor stands up in the House again in the autumn.

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