UK Budget reaction - Improved fiscal finances come with Brexit warning
David Page, Senior Economist at AXA Investment Managers, comments on the 2018 UK Budget statement:
- The Office for Budget Responsibility (OBR) made a number of changes to its fiscal assumptions that delivered a material fiscal improvement for this Budget.
- These improvements more than covered the £90bn+ in spending commitments that Prime Minister May had made in recent months, including payments to the NHS.
- The Chancellor made some additional adjustments, which allowed for further modest giveaways.
- The net effect of the sizeable adjustments to the fiscal outlook and the large increase in net spending saw only modest changes to the net borrowing outlook.
- The Chancellor looks on track to meet all three of his fiscal targets.
- Gilt issuance was reduced by £8.5bn for this year and should fall below £100k, but will return above this level from next financial year onwards.
- This outlook remains highly conditional on the outlook for Brexit and Chancellor Hammond warned that if the UK did not achieve a smooth Brexit, the Spring Statement may have to be upgraded to a full fiscal event.
Quite apart from the Budget coming early this year, the Chancellor must have thought Christmas had come early too. Significant revisions to the fiscal outlook, reflecting the OBRs changed assessments about the underlying economy, delivered a material improvement to the fiscal finances. These improvements broadly offset the over £90bn in spending commitments that Prime Minister May had made in previous months to the National Health Service (NHS), social housing and freezing the fuel duty escalator. Chancellor Hammond was able to make further modest adjustments in this budget, which allowed for additional small give-aways, but left the public finances outlook intact and on track to meet his fiscal targets. The improvement in government spending also led to an £8.5bn reduction in gilt sales this year. Gilt sales are projected to fall below £100k for the first time since 2007-08 this year, although increased redemptions will likely push them back above this level over the rest of the forecast horizon. The outlook is thus relatively upbeat and an easier fiscal stance next year is likely to further encourage the Bank of England to tighten monetary policy. However, this outlook is one that assumes a benign Brexit path. The Chancellor warned that alternative outcomes were possible and that if they materialised he could upgrade the Spring Statement next year to a full fiscal event.
Today’s Budget enacted a significant increase in spending, with tax and spending decisions combining to a net give-away of over £100bn over the six years of projections (Table 1). Most of this reflected announcements made by Prime Minister May in recent months, including NHS commitments, which accounted for £83.5bn of the total give-away. Additionally, the Prime Minister’s pre-emptive calls for a freeze on this year’s fuel duty escalator and commitments to local housing totalled an additional £9bn. However, the Chancellor was still able to find some room for his own surprises, totalling a further £11bn giveaway. This was dominated by a planned early fulfilment of the manifesto pledge to raise the personal allowance and higher tax rate thresholds to £50k and £12.5k respectively in April 2019 - one year early - and less headline grabbing changes to business allowances. However, the Chancellor did finance some of these moves with additional taxation, including the introduction of a digital services tax, reforms to off-payroll working, increases in remote gaming duty and delays to the NICS bill by one year.
Favourable changes in the OBR’s fiscal assessment afforded the Chancellor such largesse. In headline terms, economic growth forecasts were barely changed and were expected to range between 1.4-1.6% over the coming five years (from 1.3-1.5%) (Table 2). However, the OBR acknowledged that without offsetting government decisions, expected borrowing would have been reduced by £12bn in 2018-19, rising to an £18.1bn improvement in 2022-23, which would have resulted in a surplus in 2023-24. The improvement this year reflected both tax receipts (from PAYE income tax, national insurance contributions, corporation tax and VAT) having risen more strongly than the OBR expected. At the same time, central government spending has risen by less than expected over the first half of 2018-19. Looking further ahead, the OBR expects the strength in tax receipts to persist, reflecting a structural improvement. Nearly half of this was attributed to a lower estimate of the equilibrium unemployment rate (also visible in the marked lowering of the expected unemployment rate in the economy from a previous 4.6% rate projected from 2020 onwards). In turn, this raised the level of employment. Debt interest is also now assumed lower and the OBR also listed a number of smaller factors, including higher-than-forecast North Sea Oil tax revenues.
Marked improvements in the fiscal outlook, combined with the government’s decisions to increase spending, meant that the net impact on borrowing was minimal (Table 3). With the exception of this financial year and next, when PSNB is expected 0.5ppt lower than in March, PSNB is forecast to be 0.25ppt lower on average over the remainder of the forecast horizon. Indeed, the Chancellor specifically stated that he had chosen to maintain the same margin of £15bn over his fiscal mandate (structural deficit below 2% by 2020-21). The outlook for the structural deficit has not changed from March and is still expected to reach 0.9% of GDP by 2022-23. The projected debt outlook shows a more marked improvement, reflecting better nominal growth projections. Debt is expected to have fallen from a peak of 85.2% of GDP in 2016-17 to 85.0% in 2017-18 and to fall in successive years to reach 74.1% by 2023-24. The Chancellor is thus expected to achieve his supplementary target three years early. By 2022-23, public debt as a proportion of GDP this is estimated to be 2.9ppt lower than March’s estimates. The OBR also noted that the Chancellor’s third fiscal rule of welfare spending falling below a ‘welfare cap’ should be “comfortably met”.
The changes to the finances will also have implications for gilt issuance. The central government net cash requirement (CGNCR) was lowered by £9.4bn in 2018-19 to £31.2bn, an effect that was compounded by a £3bn additional contribution from National Savings products. This £12.5bn reduction in financing needs this year was met by a planned reduction in the T-bill stock of £4bn, but an £8.5bn reduction in gilt sales (across the curve). Total gilt sales this year are now planned to be £97.5bn, the first sub-£100k issuance since 2007-08. Looking ahead, future expected CGNCR was revised down by a combined £30bn over the next four years. While total gilt issuance is expected to rise back above £100bn over the coming years as the gilt redemption profile rises, net gilt issuance is set to remain below 2% of GDP through 2023-24.
We make one overriding word of warning about today’s outlook. Every Budget is contingent to the extent that changes in economic fortunes can change the outlook for management of the public finances. Rarely has a Budget been as explicitly contingent as this. The OBR’s benign economic forecasts do not include the possibility of a disruptive Brexit over the coming months. However, by the next fiscal statement the UK will either be entering a smooth transition path to exit the EU, or not. These different outcomes would materially change the outlook for the public finances and require different choices from the Chancellor. It is for this reason that Chancellor Hammond suggested that if circumstances changed, next year’s Spring Statement could be upgraded to a full fiscal event. Certainly, an unfavourable shift in the Brexit outlook could materially affect the projections in today’s Budget. With the government committing to an additional £100bn in net spending over the coming years, a deterioration of the fiscal outlook from here, could weigh all the more heavily on the fiscal outlook and could yet challenge the Chancellor’s fiscal rules.
Financial market reaction was muted and appeared more driven by international markets than domestic developments. UK 2-year and 10-year gilt yields dipped by 1bps to 0.71% and 1.40% after the Chancellor started making his statement and UK equities (FTSE 100) fell by 0.2%. However, this likely reflected the sharp 0.5% drop in the US S&P 500 index at the same time, which dragged US government yields lower. UK markets may post a more idiosyncratic reaction when they have time to digest the detail of October’s budget over the coming days.
Notes to Editors
All data sourced by AXA IM as at 29 October 2018.
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