Following a week and more of chaos in financial markets, triggered by a controversial UK mini budget, things are now on a slightly calmer course.
While the crisis of confidence in the government, that hammered the value of Sterling and sent government bond prices crashing, was soothed by the Bank of England (BoE) buying long-dated bonds in an emergency move to protect pension funds from partial collapse, the long-term wound that has been inflicted on the UK’s reputation will be slower to heal. Debt unsustainability could become a genuine issue as the UK has growing twin deficits (a negative fiscal and current account). The rating agency Moody’s has also warned that unfunded tax cuts could reduce the credit worthiness of UK debt and Fitch has downgraded the UK’s outlook from stable to negative.
UK Budget Balance (% of GDP)
Source: Macrobond, as of 04-Oct-22
The new Chancellor has announced that:
- April 2022’s 1.25% increase in employers’ and employees’ rate of NI contributions will be reversed in November
- The main rate of corporation tax will stay at 19% in April 2023, rather than rise to 25% The 1% reduction in the basic rate of income tax planned for April 2024 will be brought forwards to April 2023
- The threshold for Stamp Duty Land Tax will be increased to £250K, and to £420K for first-time buyers, immediately
A fuller fiscal statement on 31 October will detail the cost of the borrowing and measures to cut debt.
The Treasury’s detailed costing of these measures can be found here:
https://www.gov.uk/government/publications/the-growth-plan-2022-documents
UK Current Account Balance (% of GDP)
Source: Macrobond, as of 04-Oct-22
Funding the huge gap in UK finances is a concern
Even before the Chancellor’s recent fiscal loosening, the UK’s combination of high public sector debt and a current account deficit, posed risks for the economy. The move higher in gilt yields, following the fiscal announcement, showed that the UK is not immune to a loss of market faith.
In Q1 of this year, the current account deficit stood at 7.2% of GDP, by far the largest on record and one of the largest deficits globally. The deficit remained extremely large in Q2, mainly due to the surge in the cost of energy imports.
The UK current account has been in deficit for almost four decades and its further widening raises concerns. Deficits are only a problem when funding them becomes an issue. The deficit has mainly been funded by the UK selling equities and bonds to the rest of the world and there is little evidence that inward foreign direct investment, which many expected to fund the deficit, is increasing or poised to increase significantly in the near-term. This leaves Sterling struggling.
Wrong target for the tax cuts?
Collectively, the Chancellor’s recent measures equate to a £24.7 billion giveaway in 2023/24, approximately 1% of GDP. However, we believe the support this will give to an uplift in spending and consequent boost to GDP will be relatively modest. This is because the biggest winners of these policies are high earners, whose expenditure is not that responsive to changes in their income.
The Office for Budget Responsibility (OBR) estimates a relatively low fiscal multiplier effect from the tax changes (0.33). This suggests, as a starting point, that these tax cuts will boost GDP by only 0.33% in 2023/24—because some people will save the windfall or use it to purchase assets, while others will spend the money on imported goods and services.
Only one side of the equation revealed
Meanwhile, the Chancellor has so far remained silent on his plans for government spending. Will these tax cuts be part-funded by reductions in public sector investment, which the OBR thinks has a higher (1.0) multiplier and which the previous government planned to increase sharply? There is also the question of state benefits. Will their value increase next April in line with this year’s rate of CPI inflation? We won’t really know by how much the overall stance of fiscal policy has loosened until we get all the details in the Budget.
All told, we believe that the economic outlook has not been transformed by the recently announced tax cuts. The government will need to focus much more on policies to boost labour supply if it is to have any chance of hitting its target of raising the economy’s trend growth rate to 2.5% per year.
Consumer confidence takes another hit
For many months now consumer confidence has been slowly eroding due to concerns about the cost of living against the backdrop of rising inflation, triggered in part by the war in Ukraine. As well as rising energy bills and food costs, higher interest rates have added to the pressures. Throw into the mix sterling weakness and the outlook deteriorates further. The cost of imports goes up, hitting households and balance of payments earnings from exports, further widening the deficit.
UK Consumer Confidence Index (GfK)
Source: Macrobond, as of 22-Sept-22
For many months now consumer confidence has been slowly eroding due to concerns about the cost of living against the backdrop of rising inflation, triggered in part by the war in Ukraine. As well as rising energy bills and food costs, higher interest rates have added to the pressures. Throw into the mix sterling weakness and the outlook deteriorates further. The cost of imports goes up, hitting households and balance of payments earnings from exports, further widening the deficit.
UK Consumer Confidence Index (GfK)
Source: Macrobond, as of 22-Sept-22
There is no doubt consumer spending does receive a boost from the government’s interventions, especially the cap on energy bills. While energy prices will rise by 27% in April, this is far less than the 80% increase that was on the cards before prices were frozen. And, households are still set to receive, in October, the £400 Energy Bills Support Scheme grant, announced by the former Chancellor. As a result, the average monthly household energy bill should fall to £142, from £164 at present.
The full picture is less rosy, however. Before the BoE’s intervention on the bond markets, gilts were savaged with 2-year yields rising some 36 basis points (bps) – one of the biggest daily jumps of the past three decades. Although the Bank’s actions have tempered the rise in gilt yields there is no escaping that the wholesale cost of borrowing has re-set higher. As well as the risk posed to pension funds, the surge in borrowing costs has led to the withdrawal of cheaper mortgage offers and a leap in corporate lending rates.
With reportedly 40% of mortgage-holders seeing their fixed-rate deals expire by the end of next year, the impact on households cannot be underestimated. Markets are expecting the central bank to increase interest rates by 1% or more on 3 November, the date of its next scheduled announcement, with a peak rate of 5.7% in June next year. Gilts have undergone a massive hawkish repricing this year but we think the bulk of the adjustment is complete.
