OBR not OBN, but still VILE

The Office for Budget Responsibility has lost its OBN as it has cut its forecast for 2011 from an initial forecast of 2.1% to 1.7% at the time of the March Budget and further to 0.9% in the autumn statement. The fiscal agency has reduced its outlook for 2012 even further from an initial forecast of 2.5% to just 0.7%. This latter estimate is consistent with our own forecast for the year.  The OBR provided three important justifications for this considerably less rosy scenario. First and foremost has been the European Sovereign Debt crisis and the agency notes that while its central forecast assumes that the single currency will resolve its present difficulties, the downside risks are considerably greater than the upside risks. We agree, Europe is expected to slump into recession over the next couple of years, but debt haircuts rather than currency devaluation are the most likely outcome for the peripheral economies. The OBR also cites the “external inflation shock” (no mention here of the VAT hike) as a result of the “unexpected rise in energy prices and global agriculture commodity prices” resulting in a contraction in real personal disposable income of 2.3% during 2011. The third factor identified by the OBR shows that “an even bigger component of the growth that preceded the financial crisis was due to an unsustainable boom”. Moreover, according to the Office for National Statistics, the bust was even deeper than previously though and the recovery weaker forcing the OBR to significantly reduce its estimates of spare capacity and the trend rate of growth, which in turn heightens the structural budget deficit.

This latter explanation is the most important. The OBR has acknowledged that much of the growth during the Brown years was driven by an unsustainable leverage boom. Britain has the highest structural deficit amongst the major industrialised economies because it has excessive debt levels. The high level of government, consumer and financial sector debt has damaged productive potential. The OBR assumes that productive potential will gradually recover over the next couple of years with the economy able to grow by 2.1% during 2013, 2.7% during 2014 and by 3.0% in both 2015 and 2016. These lower growth forecasts cascade through the deficit targets over the next few years and despite being on target over the first seven months of the fiscal year, the OBR assumes that the deficit in the current fiscal year will be £5bn higher at £127bn as nominal GDP growth slows sharply during the final two quarters of period. The deficit for 2012/13 is expected to be £19bn higher than the March assumption at £120bn, and the deficit is expected to fall further to £100bn in 2013/14, £79bn in 2014/15, £53bn in 2015/16 and £24bn in 2016/17 and in total the deficits will be £111bn higher than the March estimates.  Additional tightening equivalent to 0.5% of GDP in 2015/16 and 0.8% in 2016/17 and according to the Chancellor allows the government to meet its twin targets of eliminating the structural budget deficit on a five year rolling basis and a peak in the debt to GDP ratio by the end of the forecast horizon.  The OBR is not so self assured estimating that there is a 60% probability of these targets being met. We believe that this is wildly optimistic and believe that there is virtually no circumstances in which the government will meet its targets over this time horizon. Indeed, deficits are likely to be at least £75bn higher again by 2017.

The OBR’s belated acknowledgement of the deleveraging threat is welcome, but it is still too hopeful. After Mervyn King’s NICE decade of Non-Inflationary, Constant Expansionary decade between 1997 and 2007; we are now experiencing a VILE decade of Volatile Inflation and Limited Expansion, which we expect to last from 2008 until 2018. The history of major financial crashes and resulting deleveraging suggests that there will be several years of very weak and volatile growth and that the pervasive deleveraging across the major industrialised economies means that these conditions are likely to persist through most of the decade. This suggests that growth is likely to average 1.5% per annum in the remainder of the decade. The myriad of measures announced by Chancellor in the autumn statement are a welcome attempt to drive both demand and supply in the economy and we believe that these efforts will have to be redoubled in future years, but the stark reality is that they are unlikely to produce a significant improvement in underlying growth over the period. This means that Plan B will remain the Bank and we continue to expect the Bank of England’s Monetary Policy Committee to increase its asset purchase facility by a further £75bn in February and again by £50bn over the summer. This will bring the total facility to £400bn by the end of 2012, but we expect additional quantitative easing programs during 2014 and 2016.

Growth is lower and deficits are higher over the forecast horizon and this will not matter for gilts, which remain one of the best horses in the global rates glue factory. The government’s commitment to fiscal austerity and more importantly independent monetary and foreign exchange policy should maintain the gilt market’s triple AAA safe haven status. There is a shortage of safe havens and we believe that this shortage will continue to drive down benchmark spot yields amongst these safe havens below 1% over the next eighteen months. The main beneficiaries of this continued outperformance will be medium and long dated gilt forwards, where the issuance and BOE buyback program continues to drive demand.  Moreover, as the massive deleveraging of the government, consumer and financial sectors highlight, quantitative easing will not be inflationary during this period and we do not expect any material weakness for Sterling as a result.