Let’s have a dram this weekend
The Chancellor’s Autumn Statement has dominated politics and been the focus of attention for UK investors this week. There has also been a stream of statements from central bank governors in the USA and Europe. At the end of the day, apart from small increases in short-dated bond yields in the States and EU, and a small fall in longer dated gilt yields in the UK, there was little change in fixed income markets. After weeks of considerable volatility, a lot of news is now in the price.
The Financial Times had summed up the dilemmas facing the Government: ‘ Prime Minister Rishi Sunak and Jeremy Hunt have a huge economic and political puzzle ahead of them. The size of the fiscal consolidation required is on a par with Britain’s 2010 “austerity” budget. But this time, the Chancellor will have to roll it out when inflation is near a 40-year high and interest rates are rising. The fiscal plan needs to appease many. But if it fails to satisfy markets, it will leave Britain’s international credibility even more in tatters’.
In the event, the statement largely satisfied the markets. The Treasury had spent the last few days giving dire warnings about the tough times ahead requiring difficult decisions. Whilst the details are myriad, the big picture is simple. Jeremy Hunt set out tax increases reaching £25 billion by 2027, a mixture of windfall taxes and freezing allowances so, for example, about one quarter of taxpayers become higher rate payers. The overall tax burden of 37% of GDP will be a post war record. He also announced £30 billion of spending cuts by 2027, largely through reductions in capital spending. The figures satisfy the Office for Budget Responsibility; if all falls into place then public sector debt will fall as a share of GDP by the end of the five-year forecast period. A critic could argue that while the tax changes take immediate effect, many of the spending cuts are scheduled after the next general election. Nevertheless, the government has swallowed the harsh medicine, carried out a speedy U turn and adopted fiscal orthodoxy.
The long-term fiscal backdrop remains alarming. After a Covid shock and then an energy crisis affecting the structure of the economy, followed by a worldwide rise in borrowing costs, the country faces serious debt servicing pressures. The OBR estimates that a weak economic outlook will force government borrowing above £100 billion both this year and next, and still as high as £70 billion by 2026-27. This reflects higher interest rates on government debt, lower tax revenues from weaker growth, and higher welfare payments from higher inflation – all without the benefit of Bank of England QE bond purchases to keep the overall burden under control.
The global backdrop is also unhelpful to the Chancellor. This week the IMF warned that “readings for a growing share of G20 countries have fallen from expansionary territory earlier this year to levels that signal contraction” whilst “the challenges that the global economy is facing are immense and weakening economic indicators point to further challenges ahead”. The impact is apparent on the UK, already a slow growing economy and with little in the Autumn Statement to alter such a trend. GDP is projected by the OBR to contract by 1.4% next year and is not forecast to recover to pre-pandemic levels until the end of 2024. Even then, inflation in 2023 is still projected to be as high as 7.4%, not a helpful backdrop for doves on the MPC.
Turning to shorter-term economic data, there are suggestions that the Bank might raise rates by only 0.5% in December. True, headline inflation was worse than expected in October, 11.1% from a year ago, the fastest rate in 41 years, driven by food, gas and electricity costs. However, the core rate of inflation was unchanged at 6.5%. Average weekly earnings excluding bonuses rose faster than expected, up 5.7% compared with a year ago. Yet, the unemployment rate edged higher from 3.5% to 3.6%. This is despite almost half a million additional people registered as out of the workforce due to long-term illness than before the pandemic began. The number of vacancies also fell for the fifth successive month.
For once the relative calm in other markets meant an easier backdrop for the UK gilts market.
There was a modest reassessment upwards in US interest rate expectations. This was no surprise as a stream of Fed governors pushed back against the market view that the central bank might soon pivot to fewer rate hikes. To quote from a few of them, Christopher Waller noted that “I will not be head-faked by one inflation report”. “We’ve seen this movie before”. “We’ve still got a ways to go. This isn’t ending in the next meeting or two”. Fed vice chair Lael Brainard felt that “The market seems to have gotten way out in front on this. Everybody should just take a deep breath, calm down. We have a ways to go yet.” Raphael Bostic argued that “Tighter money has not yet constrained business activity enough to seriously dent inflation”. “I anticipate that more rate hikes will be needed”.
Economic news in the States will worry Fed officials. Retail sales were stronger than expected in October, helped by price discounting. The annual rate of increase of the Atlanta Fed’s Wage Growth Tracker has rebounded to 6.4%, below its summer peak but still uncomfortably high. The New York Fed’s Survey of Consumer Expectations showed that households’ inflationary expectations had taken a modest turn for the worse. The Fed also has to consider the impact of a sizeable 4% fall in the trade weighted value of the dollar in a single week. All in all, market expectations wax and wane but 0.5% in December and another 0.5% in Q1 2023 are still the consensus view.
The ECB is in a similar position – more needs to be done. Yes, the EU has lowered its 2023 GDP estimate from 1.5% to 0.3% but it raised its CPI forecast to 7%. Euro area consumer inflation expectations are still running about 5% whilst wages are growing about 5% year on year. No surprise then that Bank of Italy Governor Ignazio Visco said the ECB will have to continue raising rates, albeit there is a growing case for doing so less aggressively if inflation remains on course to return to 2% by late 2024.
If all the news is in the price, then new news is required to start a new momentum in the markets. There are many candidates, perhaps the Chinese economy opening up, perhaps developments in Russia, or climate change, or politics. Meantime the Chancellor might enjoy the glass of whisky this weekend at No 11 which he did not allow himself to enjoy at the dispatch box.
Bond yields at the time of writing
% 2 year 5 year 10 year
USA 4.45 3.93 3.76
UK 3.10 3.25 3.19
Germany 2.14 2.00 2.02
Andrew Milligan is an independent economist and investment consultant. This note is offered 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