MUNIX COMMENTARY – 28th October
Good news today, less so tomorrow
For much of the year, the financial markets in the UK are focused on a stream of economic data and central bank commentary. However, the Budget and the Autumn Statement are triggers for investors to turn their attention to political decisions and fiscal commentary. What does the latest statement from Rishi Sunak mean for the bond markets?
It must be emphasised that, first and foremost, the Budget statement is political theatre. For a few days before and after, the Treasury attempts to control the political agenda and newspaper headlines with a series of good news stories. This time was no exception, with the Chancellor handing out large sums to favourite sectors: the NHS in England will receive an extra £6bn in funding, while the skills agenda, and the Northern powerhouse also gained useful sums. Sadly such announcements rarely detail the difference it might make. Taxes associated with faster economic growth in 2021-22 and the rise in asset prices, such as capital gains, provided the firepower for such spending. All in all, the Chancellor was proud to announce a Budget that combined a renewed commitment to fiscal discipline, of course, with extra spending on essential public services and (limited) measures to tackle the cost-of-living crisis.
Away from the political theatre, however, it is worth focusing on some of the key data: the latest economic forecasts from the OBR and the details from the Debt Management Office. The UK’s public sector debt is high, debt servicing costs are rising, the tax base is expected to grow very slowly from 2023 onwards, and higher rates of inflation or interest rates will cause serious difficulties for the Treasury.
At its next meeting, the Bank of England will assess how contractionary fiscal policy will become over the next few years. Fiscal policy has already begun to tighten in 2021, reflecting for example the end of the furlough scheme which was recently costing about £4bn a month, and will become more so in 2022. In the first 9 months of this fiscal year, the deficit was about 9% of GDP, down from 13% of GDP for 2020. Next spring, the Bank will pay particular attention to the state of the labour market and the extent of the increase in wages. In that regard, Huw Pills’ recent forecast, echoed by the Chancellor, about inflation possibly reaching 5% in the spring is worrying – how quickly it falls back into 2022 is of considerable importance.
A more detailed summary of the Budget is contained in the next section.
Today’s Statement from the Chancellor needs to be seen alongside those made in March and September. Spending plans well above inflation for the next few years are being financed by sizeable tax increases and expectations for a major jump in activity and hence tax revenues in 2022. In the March Budget, Mr Sunak froze the thresholds as which income tax is paid for five years, whilst plans for higher National Insurance were announced last month. The tax/GDP ratio eventually reaches its highest in 70 years.
Sunak has set out departmental budgets up to 2024-25. He has used the windfall from improved OBR growth forecasts to top up his spending plans. Departmental spending is set to grow in real terms at 3.8% a year on average over this Parliament. Health, justice and housing benefit in particular, followed by local authorities, public R&D investment, green projects and the skills agenda, whilst a notable loser is defence. The education package falls short of what the government’s former education catch-up tsar had called for. Some of the announcements are more immediate in nature, such as keeping fuel duty frozen or reducing the taper rate in Universal Credit from 63% to 55%. However, there were no measures to assist householders with rising domestic gas and electricity bills. Whilst public sector pay has been unfrozen, it remains uncertain whether future increases will match inflation.
Turning to taxes there are some important announcements, although tapering universal credit will attract most attention in the media. Following a review, the government will reduce the burden of business rates in England by over £7 billion over the next five years. Brexit allows the Alcohol Duty system to undergo a major simplification, plus changes to Air Passenger Duty (cut for UK flights, higher for long distance) which may attract criticism ahead of COP26. Whilst £9bn will be spent on a range of green projects, there was no mention of carbon taxes. Nor were there any major announcements on pensions rules, inheritance or capital gains taxes.
Turning to the economy, the Chancellor makes much of the fact that IMF expects the UK to have the fastest growth rate in the G7 in 2021 and the second fastest in 2022. The OBR has revised its growth forecast from 4.5% to 6.5% for 2021. Less emphasised was the weakness thereafter. GDP growth of 6.0% in 2022 will be followed by only 1.3-2.1% in the next four years. Investment picks up but consumer spending becomes much more muted, as household incomes are restrained by higher taxes and inflation. According to the new forecasts, over the next year the take-home pay of a median earner will fall by about 1% in real terms. after the extra income tax and NICs
The OBR judges that the COVID-19 pandemic will lead to scarring reducing GDP by 2% by the end of the forecast period compared to its pre-pandemic March 2020 forecast. Half relates to labour market problems, the other to capital spending and productivity headwinds. The Chancellor said “My goal is to reduce taxes by the end of this parliament. I want taxes to be going down, not up”. Whether he succeeds in doing so will depend on better economic growth than forecast. More efforts to encourage enterprise and investment may be required than seen in this Budget.
The OBR expects inflation to remain elevated across 2022 and 2023. Indeed, it has noted that developments since it closed its forecast would be “consistent with inflation peaking at close to 5 per cent”. Second round effects in the labour market into next spring will be important, reflecting lower unemployment and increases in the National Living Wage. Any further energy spikes and supply side shortages are clearly outside the Chancellor’s control.
As a result of the pandemic, public sector borrowing reached £320 billion or 15% of GDP in 2020-21, taking national debt close to 100% of GDP. The forecasts are for a steady improvement, helped by the jump in the tax base from 2022 onwards. Borrowing should be only £180bn this year and come down to a more manageable £60bn (2.4% of GDP) by 2023-24 and £46bn (1.5%) by 2026-27. Gilt sales remain high at some £200bn in 2021-22, hence there is no urgency for the Bank of England to taper quickly next year.
There are warnings about potential problems ahead. The fiscal impact of a one percentage point rise in interest rates in the next year would be six times greater than it was just before the financial crisis, and almost twice what it was before the pandemic. Put another way, a sustained one percentage point rise in interest rates and inflation is estimated to cost an extra £20 billion in 2024-25, rising to £23 billion in 2026-27.
Eventually taxes and spending plans will bring national debt under control. There is a steady rise in the tax/GDP ratio, reflecting for example the health and social care levy, eventually reaching over 40%, the highest in 70 years. The IFS estimates that this year has seen the biggest set of tax-raising measures since 1993, although it also notes that there is huge uncertainty over the outlook for the economy and it remains to be seen whether the tax rises will be implemented as announced. The OBR forecast confirms the fiscal mandate is met with public sector net debt peaking at 98% of GDP this year, while new fiscal rules about current and capital spending are met, of course.
In terms of market implications, the immediate reaction understandably shows little concern by investors. The decline in the FTSE100 index is in line with other European markets. Individual sectors and companies, e.g. housing or drinks or defence, will benefit to a greater or lesser
degree. Lower gilt yields partly reflect lower oil prices as much as forecasts of slightly less future debt issuance. Sunak’s admission that inflation will rise further was previewed by the Bank of England’s chief economist a few days ago.
In summary, the Budget provides much for the Government’s supporters to talk positively about. The longer-term picture, however, is a continual squeeze on household incomes causing slower economic growth unless measures to boost productivity eventually come through. Another unexpected shock would be difficult for the economy to recover from without a return to considerable Bank of England support.
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