- Chancellor Hunt’s statement means we now have both the fiscal and monetary authorities hitting the brakes hard
- The fiscal squeeze has been justified by the need to restore financial stability, but we are concerned they may be overdoing matters
- The move to sustainable finances has undoubtedly been achieved, but at the expense of pushing a weakening economy further into recession
The Bank of England, the Office for Budget Responsibility and most outside forecasters agree that the UK is on the brink of recession. The textbook response would be a fiscal stimulus. Yet the new chancellor, Jeremy Hunt, announced on 18 November the exact opposite: a major fiscal contraction with higher taxes and lower spending. His predecessor Kwasi Kwarteng’s ill-fated mini-budget was characterised as pressing down on the accelerator just as the Bank of England were hitting the brakes; we now have both the fiscal and monetary authorities hitting the brakes hard just as the economy suffers a huge headwind from higher food and energy prices. Tough times indeed.
To a large extent the fiscal squeeze has been justified by the need to restore financial stability after the turmoil induced by the Liz Truss/Kwarteng government. But we are concerned that new prime minister Rishi Sunak and Hunt may be overdoing matters. The terms of trade shock induced by skyrocketing food and energy prices in particular is cutting consumer incomes by 5% in real terms, according to some estimates1. Rising mortgage rates represent a further knock to disposable incomes both directly and indirectly by the likely recession in house prices. And Europe, our biggest trading partner, is also going into recession so we can expect little help from overseas demand. The OBR estimates that living standards (as opposed to GDP) will fall by 7% over two years, knocking out eight years of growth2.
Inflation has risen further and faster than expected in the UK. We can be reasonably confident, however, that base effects will lead to a decline in 2023 – the 90% rise in home energy bills recorded in the latest figures will not be repeated given the energy price scheme goes up by “only” 20% – and the recession will quell domestic pressures.
One of the benefits of a tight fiscal policy is lower interest rates. Indeed, base rates will undoubtedly rise more slowly as a result of this statement. Yields on conventional gilts have also fallen in absolute terms and relative to those in other countries as the markets have anticipated the announcements made in the statement. This lowers debt interest costs. Yet there is one glaring exception to this: indexed-linked gilts are based on the retail price index which has risen by an extraordinary 14.2% over the past year. This uplift feeds directly into the government fiscal deficit. The decision by the BoE to exclude index-linked gilts from the Asset Purchase Facility means they now account for more than half of outstanding government debt. This link will be severed from 2030 but for now represents an unwelcome and unexpected strain on the public finances – a serious source of weakness in inflationary times.
The chancellor has avoided increasing income tax rates but has frozen tax-free allowances for most categories. This is a significant “stealth tax” at a time of high inflation. The thresholds for capital gains, the higher rates of income tax and for dividend income have been cut. Pensions will be uprated in line with inflation. This, together with windfall taxes on renewable energy suppliers, is characterised as putting the burden on the shoulders of those most able to bear it. Yet the tax burden will rise for almost everyone, there were no changes to the politically sensitive exemption for non-doms and carried interest and the bank tax surcharge has been cut.
The move to sustainable finances has undoubtedly been achieved, but at the expense of pushing a weakening economy further into recession. UK equities are cheap and may perform relatively well as risk assets struggle globally. UK bonds will be supported by lower-than-expected supply, the weakness of the domestic economy and falling inflation, though most of the gains are behind us. After a truly dreadful year for investors and ordinary folk alike, tough economic times lie ahead.
