UK reaction: Spring Budget 2017: Spring forward, Fall back?

David Page, Senior Economist at AXA Investment Managers (AXA IM), comments on today’s Spring Budget:

Key points:

• In a budget with few measures focus centred on economic and borrowing figures.
• Public finances were markedly improved for this year compared with November’s estimates. Borrowing was £24bn lower over the forecast horizon (£17bn in the current year). Debt was expected to peak at 88.8% of GDP next year down from 90.2%.
• Economic forecasts were revised higher for next year (to 2.0%), but were lowered in subsequent years. We consider real GDP forecasts modestly optimistic.
• Nominal GDP was forecast to rise by 24% from 2015-16 to 2021-22 (similar to 24.5% in November). We see upside to this outlook (despite real GDP doubts) forecasting a more persistent inflation pick-up.
• Gilt sales were maintained at £146.5bn for 2016-17. But a marked reduction in borrowing needs this year will reduce gilt sales next year. Gilt sales are projected to be £115.1bn in 2017-18.

“Chancellor Hammond delivered his second fiscal statement today and his last Spring Budget. Expectations for this statement were lower than in November, when a deteriorating economic backdrop contributed to a material worsening in the public debt outlook - to the tune of 10% points of GDP. These lowered expectations were broadly met.

“The Chancellor benefitted from the Office for Budget Responsibility (OBR) maintaining its outlook for economic activity (albeit re-profiling this over the next few years). He also benefited from a number of one-off changes to the public finances and revisions to borrowing in the first half of 2016-17. Both contributed to a lowering of the public borrowing outlook by £24bn over the forecast horizon. Yet given this improved backdrop, Chancellor Hammond still ensured that measures introduced in this budget were broadly fiscally neutral (providing a net giveaway of £0.18bn over the coming five years). This allowed the Chancellor to retain a forecast that could suffer an additional £26bn in borrowing before breaching his new fiscal mandate, despite a deterioration in the OBR’s structural forecast; it also meant that public sector net debt (PSND), that had been forecast to peak above 90% in November, was now forecast to peak at 88.8% in the coming fiscal year.

“The main measures announced by the Chancellor were well-flagged ahead of the announcement, including additional funding to social care (£1.2bn in the coming year and further £1.2bn over the subsequent two years); a transitional arrangement for business facing a rates revaluation in June (£0.4bn); and an extension of the free schools programme (with projected costs of close to £1bn falling in the next Parliament). As trailed, much of these costs were met by proposed changes to the tax treatment of self-employed workers (raising £4.7bn). Beyond that, measures in this Budget were relatively thin on the ground allowing the Chancellor to spend time discussing voting rights, centenary commemoration plans, and funding for ‘returnships’, which were expected to cost £5m each.

“Brexit continues to cast a long shadow over these projections. While the borrowing figures could come in better than expected in the coming year reflecting better momentum and upside nominal GDP growth risks, looking further ahead the outlook for real GDP underpinned by the UK’s potential growth will be critical. We are more pessimistic than the OBR over this outlook and the impact Brexit will have is highly uncertain. As such, we consider Chancellor Hammond’s instinct to continue to hold some reserve as, dare we say, ‘prudent’. Our concern is that should UK activity fall short of the OBR’s 1.8% projected annual pace over the next five years, the Chancellor’s £26bn headroom could disappear very quickly.

Measures

• The measures were basically estimated to be fiscally neutral over the five year horizon (a net £175m give-away).
• Additional funding for social care, boosting funding by £1.2bn in 2017-18, £0.8bn 2018-19 and £0.4bn in 2019-20.
• To provide some transitional relief from the business rate uprate, including a discretionary support fund, capped increases for small business rate payers and a discount for small pubs, totalling £445bn over the coming years.
• Funding for extended free schools programme. This is forecast to cost £100bn in this Parliament, but rise to £280bn in 2020-21 and £655bn in 2021-22.
• Revenue was primarily increased through measures to increase taxation on self-employed workers, both through an increase in Class 4 National Insurance Contributions (NICS) and a reduction in the dividend allowance to £2k. Taken together these were projected to raise Around £5bn. 

Economy

• The OBR forecast GDP to rise by broadly the same amount over the coming five years in nominal terms as in November.
• Real GDP was re-profiled over the coming years to 2.0% (from 1.4%) for 2017, 1.6% (1.7%) for 2018, 1.7% (2.1%) for 2019, 1.9% (2.10%) for 2020 and 2.0% (2.0%) for 2021.
• The upgrade to 2017 growth is in line with Bank of England (BoE) assumptions, although runs slightly ahead of our own outlook (1.7%).
• The modest softening thereafter looks appropriate in the light of Brexit risks around late 2018/2019 and forecasts here will be very dependent on the nature of and scope of the exit negotiations. 
• To our minds, the OBR real GDP forecasts remain on the optimistic side.
• The OBR once again lowered its projected trend output growth for the previous year as productivity growth failed to rebound as forecast. It left its productivity projection unchanged rising to close to double the 2016 rate by 2020. Potential growth is estimated just shy of 2% 2017-19 and at 2.0% thereafter. We assume a modestly slower pace of trend growth over the coming years, which accounts for our modestly more downbeat outlook for growth over the coming years.
• Yet we forecast a faster pace of inflation growth, which we suggest sees some upside risk to the OBR’s nominal GDP forecast, which will be the critical factor for the borrowing figures.

Public Finances

• The public finances recorded improvement in March from November.
• Public sector net debt was revised lower to  peak at 88.8% in 2017-18 (from 90.2%), but then to fall back (if it happens for the first time since 2000-01) to 88.5% (89.7%) in 2018-19, 86.9% (88.0%) in 2019-20, 83.0% (84.8%) in 2020-21 and 79.8% 2021-22.
• Public sector net borrowing was also projected lower for 2016-17 to £51.7bn (from £68.2bn), £58.3bn in 2017-18 (from £59.0bn), £40.8bn (£46.5bn) in 2018-19, £21.4bn (£21.9bn) in 2019-20, £20.6bn (£20.7bn) in 2020-21 and £16.8bn (£17.2bn) in 2021-22.
• The major source of improvement is actual, not forecast. It reflects a materially better outturn for this year, which the OBR ascribed to classification changes (particularly corporation tax time-shift changes) and a material adjustment to the H1 2016-17 deficit compared with figures recorded by the ONS in November. Tax take rose sharply in 2016-17 (something the OBR had forecast for 2017-18). The OBR now does not assume further tax take increases in the coming year.
• The projections show the structural deficit below the government’s 2% mandate by 2020-21 (currently estimated at 0.9%). This provides £25.8bn headroom to the target. However, this did not reflect the £24bn improvement in borrowing. This was because the OBR had also reduced its trend growth forecasts meaning that this £24bn addressed a structural deterioration. 
• The government is also on track to see public sector net debt fall (as % of GDP) in 2020-21.
• We see a number of broad risks to the public finances:

i) Better momentum in this year’s finances continues into 2017-18, this would suggest some modest further improvement in the short-term.

ii)  We also expect a faster pace of CPI inflation. This should see nominal GDP if anything a touch faster than the OBR currently forecasts particularly over the next two to three years.

iii) Yet we are more pessimistic about the outlook for real GDP growth.

iv) We also estimate UK potential GDP growth slower than the OBR, reflecting a modestly more pessimistic outlook for productivity growth. This risks a deteriorating structural deficit. 

Gilt financing arithmetic

• The change in the deficit projections have also had an impact on the outlook for gilt sales.
• The cash deficit (net cash requirement) was reduced by £13.2bn from November.
• The DMO’s overall net financing requirement fell by a greater £16.4bn, reflecting an additional £3.2bn financing from National Savings in 2016-17.
• The DMO left gilt sales at £146.5bn for 2016-17, absorbing the smaller borrowing requirement with reduced planned T-bill issuance (£2.1bn) and building the DMO net cash position (by £14.3bn).
• Most of this will be unwound in 2017-18, reducing gilt sales in that year. DMO cash holding will be planned to reduce by £14.3bn and planned T-bill issuance will fall by £9.5bn, reducing gilts by £23.8bn. This suggests gilt sales of £115bn in 2017-18.
• We forecast gilt sales at a similar level in 2018-19, but see these rising to around £125-130bn thereafter as financing for National Savings product eases and gilt redemptions rise.

Financial market reaction

• Financial markets were left little changed on the day. Gilt yields underperformed international markets initially (a move compounded with strong US employment survey evidence). However, yields retreated after the initial rise to close with 10-year yields up 3bps at 1.22%. This was in line with US Treasury 10-year yield increases.
• 2-year yields retreated by 1bp to 0.08%.
• Sterling rose initially only to retrace all gains against the dollar, but remained modestly firmer to the euro.
• UK equities rose by around 0.25% (both FTSE 100 and FTSE 250). 

ENDS