BrexitNov 7 2018

Fiscal Phil keeps room for Brexit

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Fiscal Phil keeps room for Brexit

Uncharacteristically, he reallocated this windfall to future spending. So how much more is Philip Hammond forking out?

By the end of the current Parliament, the government will spend an additional £17.9bn while raising just an additional £280m in taxes. 

But remember, this is relative to the spending plans already set out. That’s crucial to assessing the validity of Mr Hammond’s proclamation that “austerity is coming to an end”. It is no more than rhetoric and the politically-neutral Office for Budget Responsibility's (OBR's) report tells a different story. 

Mr Hammond previewed the spending review by announcing that day-to-day spending limits will rise by an average of 1.2 per cent a year.

At best, fiscal policy won’t be getting any more austere in 2019 to 2020, but the OBR’s numbers clearly show that the cyclically adjusted budget deficit will tighten again from 2020 to 2021. And that’s after eight long years of extraordinary fiscal tightening. As a result, we are not changing our outlook for the UK economy. Low growth and tight fiscal policy is here to stay.

The ‘giveaway’

Nevertheless, public sector net borrowing is likely to be 1.9 per cent of national income this year, back in line with the 70-year average, albeit still above the 1.3 per cent average seen during the Tony Blair years (1997 to 2007).

But a net giveaway Budget does not reverse eight years of austerity. Sure, total real spending has fallen by just 1.5 per cent from a peak of £800bn in 2010 to 2011, but this must be seen in the context of an increasing, aged population that requires more government services. In this context, eight years of cuts were deep and unprecedented. The average department’s budget was cut by 20 per cent.

All told, total public spending as a share of GDP has fallen from 45 per cent in 2009 to 2010 to 38 per cent, close to the US’s 36 per cent which has always been viewed as disconcertingly low.

Mr Hammond previewed the spending review by announcing that day-to-day spending limits will rise by an average of 1.2 per cent a year. However, the OBR clearly illustrates that real expenditure limits per capita will not rise at all once we exclude the NHS. Moreover, the government has discretely slashed the money set aside for long-term capital spending in the coming years. According to the OBR, the capital spending budget has been cut by £7bn per year in 2020 to 2021.

The fiscal rules

The chancellor delivered his net giveaway Budget while lowering the national debt to GDP ratio by 2020 to 2021 and keeping the structural deficit below 2 per cent of national income. But he had to jettison one of his fiscal rules and a manifesto pledge to run a fiscal surplus from the mid-2020s.

Reneging on the rule shouldn’t concern investors; we have had 12 fiscal rules since 1997, and 10 of those have been broken or abandoned. Markets rarely bat an eyelid. It’s been seven decades since there were four consecutive years without a deficit.

Gilt yields were unmoved. Unsurprising given that the UK has the second lowest public debt to GDP ratio among the G7.

Raising the minimum wage

The 4.9 per cent rise in the national living wage will help lower-income households. Someone, somewhere must pay for higher minimum wages. Either domestic firms make less profit, cut jobs or other benefits, or pass the costs onto households in the form of higher prices.

In practice, there’s precious little evidence that firms cut jobs as a result of higher minimum wages. But that may be because the historic examples start from a relatively low base. Theoretically, there must be a point beyond which higher minimum wages lower employment, but that point is unknown.

We do not expect the higher living wage to exert significant pressure on inflation - historically this relationship has been very weak.

Tax on big tech

The new “tech tax” is aimed at technology platform providers with large revenues. A new tax on business is not something one would expect from a Conservative Chancellor, especially one designed with explicit interventionist intentions. However, it could be seen as correcting for a market distortion created by the tax loopholes that online companies use so deftly. 

After a year with a net outflow of foreign direct investment, one might be concerned about disincentivising investment from globally dominant companies. But it is a sign of the times for techs. The next decade is likely to see a tightening of regulation in all jurisdictions and we are keeping an eye on long-term earnings projections.

Having said that, big tech appears committed to maintaining UK headquarters, despite Brexit uncertainty. 

Do we need Brexit ‘headroom’?

The Chancellor maintained headroom of around £15bn against his fiscal rule to reduce the structural budget deficit to 2 per cent of GDP by 2020 to 2021. 

We sometimes hear that forecasts of economic deterioration were wide of the mark after the referendum, so pessimistic forecasts may be similarly wide of the mark after a “no deal”.

That said, those post-referendum forecasts may not have been as wrong as you might think.

For example, after the referendum the Bank of England estimated that GDP would increase by just 0.5 per cent over the 12 months to June 2017, after which the economy would gather more steam and increase by 3 per cent to September 2018. Actually, GDP increased by about 2 per cent over the first 12 months, before decelerating to grow by 1.5 per cent to September 2018 (we’ve estimated the final quarter based on the monthly data available so far).

So, while the popular narrative has it that the initial forecasts were way off, the 27-month forecast was actually spot on; the economy just took a different route.

At the time, we thought other forecasters’ initial estimates were too pessimistic but the first 12 months beat even our expectations, largely because households unexpectedly decreased their rate of saving. 

Key Points

  • The outlook for the UK economy remains unchanged, with low growth and tight fiscal policy ahead.
  • The new "tech tax" could be seen as correcting for a market distortion.
  • The Chancellor has maintained some fiscal headroom in preparation for Brexit.

The size of the UK’s trade in services relative to its economy is bigger than any other large advanced economy’s. Its manufacturing is one of the most specialised, involving above average use of overseas supply chains. Even if Brexit eventually turns out to be a great change of direction, the disruption to regulatory regimes and supply chains that a hard Brexit would entail over the short to medium term means that the likelihood of investment surprising to the upside is very low indeed. 

So, in short, the Chancellor is wise to keep some fiscal headroom. 

We believe the most likely outcome next year is a deal de minimis with the salient details still to be hammered out during an extended negotiating period. Indeed, in the past fortnight the EU and UK have reportedly considered a year’s extension to the two-year transition period, taking us to December 2021.

However, that would overlap with the start of the EU’s next seven-year budget cycle, and could leave the UK liable for a bigger ‘divorce bill’. 

Economically, by preserving ‘business as usual’ for another three years, a transition extension would likely be positive for the economy. That said, it sustains the cloud of uncertainty and could potentially hold back investment decisions for longer.

The bottom line is that neither the Budget nor Brexit are globally important events, and the global revenue streams underlying most investors’ portfolios should be unmoved. 

Ed Smith is head of asset allocation research at Rathbones