Well, congratulations to Jeremy Hunt. He pulled off a great conjuring trick and seems to have convinced markets that the economy is safe in his hands.
The gilt market, the new key determinant of fiscal policy, was satisfied that enough was done to restore financial credibility whilst not driving the economy further into recession – a sort of Goldilocks result.
Let’s look at what has been done. Fiscal policy has been tightened – but not quite yet. Tax and spending measures mean that by the end of the forecast period in 2027-28, fiscal policy will be tightened by £55bn annually; most of the tightening is concentrated in the period from 2025-26. The tax measures are, generally, more evenly spread with a large chunk in earlier years relating to windfall taxation on energy companies. But we need perspective: the net effect of all measures announced since March 2022 is an increase in borrowing of £64bn in 2022-23 and £40bn in 2023-24.
So, the trick that has been pulled off is the backloading of fiscal tightening, thereby not worsening the recession, yet still restoring the confidence of gilt investors, resulting in the lowering of future borrowing costs. On top of that, he has protected the poorest sections of society and has created a policy dilemma for opposition parties.
The Chancellor has been helped out by a friendly Office of Budget Responsibility (OBR) assessment. Okay, the OBR does sound relatively grim about the short term: a year-long recession with unemployment rate peaking at 4.9% in 2024, house prices falling by 9% and inflation remaining high through 2023, before settling down to around 2%. The OBR also points out that 8.5% of government revenues will be consumed by debt servicing by 2027-28. However, put alongside the Bank of England’s short-term assessment, the OBR looks positively bullish.
Where the OBR has been helpful is its view on longer-term growth. And, of course, stronger longer-term growth makes the fiscal numbers add up. A short recession followed by strong economic growth, as outlined by the OBR, lacks credibility. Where is the renaissance in growth going to come from? It is unlikely to be generated by renewed entrepreneurship. Government policies appear to adversely target workers and aspiration whilst protecting, in a relative economic sense, the inactive. There has to be better ways to support the neediest in our society without rewarding some of our wealthiest.
I think we are left with an economy and society that continues to adjust to lower long-term growth, with taxes that incrementally rise to provide the minimum public services that are tolerable. The Chancellor talked about re-energising the UK, with emphasis on key areas where we have a competitive advantage. I fear it is just more rhetoric.
Where did this leave markets? Broadly unchanged is the answer. UK 10-year yields dipped towards 3.1% and short rates still implied a bank rate of around 4.5% in Q2 next year. There was some cheer for gilts in the Debt Management Office’s funding remit for 2022-23, with £24bn fewer bonds to be issued. But, and it is a big caveat, there are tremendous challenges ahead. Gilt issuance in the coming years looks daunting. The gross financing requirement next year is over £300bn. With £117bn of redemptions that still leaves £188bn to find – and that takes no account of the £80bn per year expected to be sold through quantitative tightening. Some of the deficit will be financed through Treasury bills but it still implies a lot of interest rate risk for investors to absorb. And the picture only slowly improves; over the next five years investors are expected to take down, on average, over £200bn of net supply per year.
Of course, the UK is not alone in facing these challenges. After all, there are common factors at work: changing voter expectations, the end of the Magic Money Tree, ballooning government debt, war, Covid etc. Overall, however, government bond markets were in a forgiving phase last week. Yields on 10-year US treasuries ended at 3.8% whilst the German benchmark hit 2%. US implied inflation took a step down, still reflecting the better-than-expected inflation data; US real yields hardened a bit. And there is an interesting trend developing: the real yield differential between the UK and US continues to widen. At the 30-year maturity point the difference is now 1.7%, with the US rate above 1.6% and the UK rate slightly negative; at the end of Q3 the differential was less than 1%. US Treasury inflated-protected securities look good value to me.
So where does this leave us? Given the fall in yields since early October I am back to favouring cash and short duration strategies.
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