Thoughts Ahead of the Budget

This coming week is the second Budget of the year, the first of the new Parliament and the penultimate one before the UK leaves the EU in March 2019. The UK may prolong its tenure in the EU through a yet-to-be-agreed transition deal, but even so we are just over half-way through the Article 50 Process. Given that, it is easy to see why this is being talked of in some quarters as a preparation for Brexit Budget. The question is, will it be?

In my view a Budget that prepares for Brexit needs:

1. An upbeat vision of what lies ahead, including a clear message to international investors and to firms based here of a global Britain, open to the world.
2. A clarification of the challenges that need to be addressed and the opportunities that lie ahead.
3. In addition to these broad messages, some meat on the bone, with a commitment to a business friendly environment, with increased infrastructure spending and low future tax. In particular, while it is taken as a given that the UK needs to protect workers’ rights, the Budget vision should include an aim to keep UK business taxes as competitive as possible, helping business. The government has already promised to cut corporation tax, currently 19%, to 17% by 2020.
4. Increased expenditure on necessary areas including the much talked about need to upscale port facilities, among others.

Having an upbeat vision would also be reflected in higher future GDP growth forecasts — even allowing for possible turbulence in coming years where the trajectory of growth could resemble a ‘Nike swoosh’ — and this would improve the future profile of the fiscal numbers.

Much will depend upon the Chancellor’s fiscal sums. It has taken some time for the budget deficit to be brought under control but it is now at a relatively low level and, in my view, should fall steadily further over the next year or so. The debt dynamics associated with nominal GDP growth of around 4% and yields remaining low could see a significant fall in the budget deficit.

Caution likely to dictate the approach

However, the Chancellor is likely to take a far more cautious approach: for two key reasons. One, the independent Office for Budget Responsibility (OBR), who produce the economic forecasts on which the Budget is based, will probably be cautious about immediate growth forecasts. This is not inevitable, but seems likely.

The second factor likely to contribute to the Chancellor’s caution is the inevitability of the OBR reducing their forecast for trend growth. This would bring it more into line with the Bank of England and reflect the downward revision to UK trend growth that has been ongoing since the global financial crisis of 2008. Since that crisis, UK employment growth has been solid but productivity growth has been low and it is this latter effect which will account for the OBR’s decision.

There are many factors accounting for this, including low investment. The implication of this decision by the OBR will be that more of the budget deficit will be judged to be structural, and hence long term and less of it cyclical, reflecting a temporarily weak economy. That would require the Chancellor – if he wished to stick to his fiscal plans – to limit spending or raise taxes. But the signs are he will be more flexible.

In the spring Budget the OBR forecast the economy would grow 2% in 2017, 1.6% in 2018 and then 1.7%, 1.9% and 2.0% in the following three years to 2021; leaving the economy in 2021 at the same level it had expected in their previous forecast made in autumn 2016.

Growth of 1.6% seems likely for this year, and although lower than forecast in the spring it will be far higher than was expected by most forecasters immediately after the referendum vote. Although a major revision is not warranted the OBR’s caution about trend growth may see them tweaking their forecasts lower for future years, too.

Growth could be stronger next year

I think growth next year could be around 2%, as inflation eases, wage growth rises and exports are boosted by the stronger world economy and sterling’s competitiveness. Of course, political uncertainty in the UK and the ongoing Article 50 negotiations mean there is a higher degree of uncertainty – which could impact investment plans and confidence overall.

Sterling, too, despite being very competitive, may be vulnerable to uncertainty over the EU exit and also the risk of another election — although the most likely scenario is the government remains in power, delivering Brexit in 2019, a two-year transition to 2021 and a general election in 2022. What happens then is anyone’s guess. But it also would mean this Budget would be followed by four more in this Parliament. While that may allow a Chancellor in normal times to focus more on the medium term there would seem to be a strong case to relax fiscal policy in this Budget, while reassuring the market about medium-term fiscal plans.

What then could the Chancellor announce on his fiscal plans? The message he is giving is that there will not be a big giveaway. In the spring, the Budget was broadly neutral. A £1.7 billion boost in 2017-18 being offset by planned marginal fiscal tightening in the following four years. That implied an expected further reduction in the budget deficit and debt to GDP peaking this fiscal year at 88.8% of GDP. Since then we have had an election, an announced delay in when the budget will be returned to surplus and pressure to spend more to prepare for Brexit. So expect some giveaways in this Budget.

I have argued against the approach to austerity for some time. We should have been borrowing more for infrastructure at low yields, although it is also often overlooked that there are now a significant amount of transport projects taking place.

Although some departments have seen a tight spending squeeze it is interesting to note that government spending in 2017-18 was £802 billion. In the 2009 Budget, the year after the global financial crisis, such spending was £671 billion. Thus it is hard to say public spending has been brought under control. Yet the tight squeeze on some departments not ring-fenced from spending cuts – including, for instance, public order and safety or personal social services – plus the squeeze on wages, has fed the feeling of austerity and calls for government spending to now rise.

Addressing supply and demand in housing

In addition to more infrastructure spend, kick-starting large scale house-building has been long overdue. Yet repeatedly, instead of really seriously stimulating house building we normally see measures to boost demand.

Ahead of this Budget the press is speculating stamp duty will be cut. This is not the best way to tax housing and it is also far too high. Cutting it makes sense, but another measure to stimulate demand without a large scale attempt to boost supply would not be the best outcome. Cut stamp duty by all means, but boost supply, too — and considerably.

In terms of savers and investors the most important issue will be this overall macro and fiscal stance, as that will set the mood for the markets — as well as impacting overall confidence towards the UK. In addition to the implication for UK assets, one area of importance to Netwealth portfolios will be the impact of the announcements on sterling and the corresponding translation effect of the international asset positions.

Also, any major shift in fiscal policy could influence UK government bonds somewhat. Nevertheless, we remain well diversified across countries, asset classes and currencies and remain confident that portfolios are positioned sufficiently to withstand any unexpected announcements.

After the debacle of the spring when the Budget began to unravel in a few days, an autumn Budget that provides some vision for the future and stability now would be welcome.

Please remember that when investing your capital is at risk.