ISQ – October 2024
Prof Jeremy Batstone-Carr, European Strategist, Raymond James
The summer is over and politics is back in the air. One can hardly open a newspaper or turn on the television or radio without being told that the 30 October Budget will be painful and that tough decisions must be taken if Britain is to be rebuilt. Everybody must do their bit but the reward, we are told, is a robust, resilient and more prosperous economy shovel-ready to face the demands of the future. The newly installed Labour administration, galvanised by a substantial majority in the House of Commons, is ready to lay the foundations for big changes. Instituting change is a tough challenge, but the rewards are there if the right choices are made.
The size of the challenge that lies ahead was described by the Office for Budgetary Responsibility (OBR) in its recently released “Fiscal Risks and Sustainability Report”. Gazing into the distant future the Report concludes that, if unaddressed, the UK’s public debt to GDP ratio would soar from an already high 98% to a whopping 274% in 50 years’ time. Not only that, adding in the impact of recession roughly once a decade, which typically adds to the debt pile, the projected number rises to an even more eye-watering 324%, the highest level ever by a comfortable margin and easily dwarfing the previous peak 250% at the end of WW2. In the context of the OBR’s findings, complaining about the existence of a £22bn “black hole” feels like a drop in the ocean.
Beyond simply identifying the quantum of the long-term challenge, the OBR goes further. The Report argues that just to keep the debt / GDP ratio at around 100% would require a fiscal policy tightening of 1.25% of GDP, equivalent to £35bn, each decade over the next fifty years totalling 6.25% of GDP or £176bn. In practical terms that either means shrinking the size of the state (lower spending) or a huge increase in taxation the consequence of which would surely disincentivise work, investment and saving. But before becoming too gloomy, the OBR offers a third way, growth, which in the context of the above feels like an olive branch too good to be true.
Specifically, the third option focuses on the necessity to improve the UK’s extremely low potential growth rate and the way to achieving that prize is through delivering a sustainable boost to the country’s woeful productivity track record. Quantifying the target, the OBR concludes that an increase in productivity from today’s dismal 0.3% back to pre-Great Financial Crisis levels of c.2.5% would be sufficient to drive down the debt to GDP ratio to just 65% by the mid-2070s. At issue is not the hand-wringing and gnashing of teeth articulated in the, frankly, questionable assertion that the new administration has inherited “the worst set of economic circumstances since the Second World War”, but whether Chancellor Ms Rachel Reeves and her team at the Treasury are up to the task of delivering transformation in the years ahead?
So, while the media’s emphasis lies inevitably on the role of the state and / or the size and extent of the tax burden in the very short-term, the far more important point is the creation of a framework that paves the way for a sustainable increase in targeted investment involving both the public and private sectors. Here again the OBR analysis provides guidance, concluding that a 1% increase in public investment would be sufficient to boost the UK economy’s supply potential by 0.4% after five years and by 2.5% after fifty years, driving the country’s debt to GDP ratio down to a far more manageable 65% in so doing That, then is the overarching long-term goal to be addressed at the end of October and the financial markets will be watching.
Although achieving the aspirational target is clearly a long-haul journey, the Chancellor has to make a start somewhere. With that in mind the more immediate task will be the prudent day-to-day management of the public finances, something that is likely to find favour with the gilt-edged market against widespread concern regarding the poor health of public finances and overall indebtedness globally. In that context the government’s spending plans and the extent of likely proposed tax increases are highly relevant.
With regard to the former we have already been told that day-to-day spending will increase by £22bn in the current fiscal year, mainly associated with pay awards for public sector workers. We also know that around £5.5bn will be saved by cutting spending elsewhere, amounting to a net fiscal loosening of around £16bn. Although certain specific taxes have been ringfenced (income tax, national insurance and corporation tax), tax hikes elsewhere are surely “on the table”. But despite being told the forthcoming Budget will be “painful”, just how boxed-in might the Chancellor be in reality? By delaying the Budget date for some considerable time following the election, the Treasury will have been able to reap substantial benefits from an economy growing strongly having rebounded from last year’s shallow recession. Not only that, but the Organisation for Economic Co-operation and Development (OECD) has recently upgraded its GDP growth forecasts, awarding the UK economy an “A” on its report card in so doing. The fiscal headroom against the pre-existing rule that underlying debt must be falling as a share of GDP in five years’ time increases from £9bn at the last Budget in March to £22bn now. Maintaining or adjusting the fiscal rules could provide even more “wiggle room” for both spending and, crucially, investment in improvements to long-term supply capacity.
The most likely course of action, though, is that the Chancellor goes ahead with £16bn of spending and pays for it with £16bn of tax increases leaving the broad fiscal policy stance unchanged. However, from the perspective of the financial markets the most important issue will be the likely impact on growth, inflation and by extension, interest rates. A neutral Budget, as described, could add c.0.2% to pre-existing GDP growth forecasts (c.1.5% in both 2025 and 2026) on the basis that higher spending adds more to near-term growth than higher taxes subtract from it. However, depending on how the money is spent the flip side to higher growth might be slightly higher inflation (little wonder the Bank of England is so cautious). However, as the labour market loosens and persistent underlying price pressures continue to fade, inflation should remain subdued and close to, if not below, the Bank’s 2% target over the medium term. This implies that while the Bank’s current caution is warranted, its commitment to lower interest rates will build as time passes and at a rate over and above that already anticipated by financial markets, an enticing prospect for investors in the gilt-edged market.