MUNIX COMMENTARY – WEEK OF 23 NOVEMBER
The highlight of this week is the Chancellor of the Exchequer’s Spending Review – not an autumn budget as there were no planned tax changes, and not a multi-year review as the future is just too uncertain, but still an opportunity for No 11 to set out its stall on three key areas: helping overcome the pandemic, dealing with the ever-competing demands for higher public sector spending, and how best to support a solid economic recovery. Where there were useful signals about the future shape of the UK economy, the implications for gilts continue to be that in the absence of inflation then higher yielding fixed income assets will remain relatively attractive to investors against the backdrop of continued Bank of England support.
This note is in three parts, starting with the Spending Review, then the forecasts for the economy and public finances as updated by the Office for Budget Responsibility (OBR), ending with some political comments.
Public spending
A flurry of ideas, leaks and reports were circulating before the statement, for example about green energy, defence spending, the aid budget, a pay freeze for some public sector workers or support for the unemployed. These are standard Treasury tactics to try and get bad news out of the way while it has several bites of the cherry over good news. Nevertheless, the balance of spending shows how political commitments are evolving in the light of the pandemic, e.g. more support for those badly affected in the labour market, and how to sustain the recovery as and when the vaccination programme takes effect, e.g. a new infrastructure bank to replace the work of the EIB, with a tilt towards the northern constituencies. The £4bn removed from the aid budget de facto funds the £4bn levelling up fund to finance infrastructure. There was ‘good news’ for most areas of government, e.g. total departmental spending set to rise by almost £15bn in cash terms, with £6bn more for health and £2bn more for schools in England, £3bn more for local authorities, £4bn for prisons, over £4bn to help people back to work, all partly paid for by the freeze on public sector pay. This is not a return to austerity – the Chancellor talked about closing the gap on the public finances over the medium term. As no tax increases are immediately in the offing, so debt issuance takes the strain, estimated at £394bn this year (19% of GDP). Big decisions on fiscal consolidation or further economic stimulus are delayed at least until the 2021 Budget.
Official forecasts
The OBR estimates that UK GDP will fall by 11.3% this year, one of the worst amongst the major economies, causing unemployment to reach a peak of 7.5% or 2.6 million people next spring. This is a reduction though from the OBR’s summer forecast of a peak in unemployment of 10%, partly because of the generous furlough support. The economic recovery is forecast to be moderate, 5.5% and 6.6% in the next two years, indicating that the economy will not return to its pre-crisis size until end 2022. This would be about a year behind estimates made by blue chip economists for other major economies. Other forecasters are more upbeat about UK prospects in 2021, expecting the vaccination programme to sustain consumer spending, financed by the precautionary savings built up by households and businesses.
Long-term scarring is seen by the OBR’s forecast that economic growth in 2023-25 is only about 2% a year, while in 2025 the economy would be 3% smaller than expected at the time of the March Budget. The forecaster warns that tax increases or spending cuts worth £20-30bn are eventually required to stabilise the debt burden. The Treasury nodded in this direction, with the proposal to alter the inflation benchmark for pensions uprating from 2030.
Such forecasts assume a Brexit deal in coming weeks, otherwise the OBR warns of a further 2% hit to UK GDP in 2021.
Public sector debt reaches almost £400bn this year and will only decline slowly to about £100bn a year over the medium term. Hence even with an economic recovery, debt is forecast to be as high as 97.5 per cent of GDP in 2025-26. The key issue for the Treasury, however, will be the levels of debt servicing, very low today of course on the back of MPC QE.
Implications for gilts
The OBR forecasts are a little more downbeat than the consensus, but not so far away as to cause major ructions in the markets. One implication from such a deep downturn and slow recovery is that inflation will remain muted for some time to come. Although the Bank of England has not officially followed the Federal Reserve’s policy of running the economy hotter for longer to revive inflation expectations, there is nothing in the OBR’s work to suggest that the MPC need alter interest rates any time soon. Indeed, negative rates are still a policy option if and when the economy is unable to snap back from the weakness expected for the 4th quarter of 2020. The onus remains on the Bank of England to support the economic recovery via continued QE, as and when the private sector does not bid for gilts. Year end strategic asset allocation rebalancing by institutional pension funds and the desire for some yield in a world of low interest rates means that fixed income remains well bid pro tem. This is even while global fixed income has come under some pressure from expectations of stronger economic activity leading to a steeper yield curve.
An important announcement for fixed income is the decision that the RPI inflation measure will be aligned with the Consumer Price Index including housing costs (CIPH) from 2030, with no compensation for holders of index-linked Gilts. One asset manager has calculated that around £100bn of value from index-linked Gilt holders would effectively be transferred to the government from its implementation. Over time there will be implications for large holders of index linked gilts, notably DB pension schemes. On the day there was a small relief rally in such debt as there had been some concern that the changes could appear much sooner than 2030.
Politics
Of course, there will be some criticism of the tone and tenor of the Chancellor’s speech, for example his talking about an ‘economic emergency’ when the worst of the recession appears to be over, or the freeze on much public sector pay when the pandemic showed the worth of key workers, or breaking the manifesto commitment on the overseas aid budget. If the economic recovery is stronger than expected into 2021, then such political attacks will fade away – and the door will open for some tax increases on the better off before the 2024 election, e.g. via capital gains or pensions tax relief. If the recovery remains W shaped, say with another economic downturn in 2021 due to further adverse shocks, then the Chancellor will face more criticism – and tax increases will be delayed, indeed more tax incentives for investment and hiring may be required. The more his hands are tied, the more the Treasury will need to rely on Bank of England QE and yield curve control to cope with the debt mountain. In other words, financial repression will enable permanently higher levels of debt in the UK – a policy Japan has successfully demonstrated for several decades.
Andrew Milligan is an independent economist and investment consultant. This note should be considered as general commentary on economic and financial matters and should not be considered as financial advice in any form.
Andrew Milligan an independent economist and investment consultant. From 2000-2020 he was the head of global strategy at Standard Life/Aberdeen Standard Investments, analyzing the major financial markets for global clients. He currently assists a range of organizations with reviews of their investment processes, advice on tactical investing and strategic asset allocation, and how to include ESG factors into their decision making