Rating agencies assessments from Fitch and Moody’s provide a timely reminder that neither the economic nor political cycles favour any material relaxation of fiscal policy in the UK. The coalition government has invested enormous political capital in maintaining the triple AAA sovereign credit rating and will not take any risks at this stage of the parliament. The fiscal squeeze will continue, albeit at a smaller pace, focussing on painful spending cuts rather than tax increases. Indeed, real spending is set to contract over the next six years forcing an unprecedented contraction in the government’s contribution to real activity.
After last year’s big tax and real disposable income squeeze, where the next fiscal tightening was £31bn, the pre-planned tightening is £18bn. This represents 1.1% of GDP and will be split between £3bn tax increases and £15bn spending cuts. Just 12% of the planned spending cuts have taken place. This share is expected to rise to 80% of the total 2009/2010 to 2016/2017 fiscal austerity program over the next few years. This squeeze on spending is more efficient and does less damage to the private sector economy than tax hikes, but it is politically awkward for the Conservatives and their Liberal Democrat allies. The spending squeeze will be all the more painful because of the weak growth environment.
We expect real GDP to grow by 0.7% during 2012, in line with the Office of Budget Responsibilities (OBR) revised December growth target, helped by the substantial stimulus from the Bank’s QE program.
We believe that 2012 growth is likely to be in line with expectations, a change from the last three years where growth has undershot the government’s expectations. This suggests that the budget outcome will be smaller than the revised target of £120bn for the forthcoming fiscal year as the mix of government revenues once again surpasses the Treasury’s cautious expectations.
The current fiscal year is tracking a £7bn undershoot of December’s revised target of £127bn and we expect a further undershoot of £3bn to the FY2012/13 target of £120bn, which will imply a deficit to GDP outcome of 7.4%. We doubt that the Chancellor will announce a lower 2012/13 target on Wednesday, preferring instead to include a margin of error into his calculations to take account of the risks to global growth. The European Sovereign Debt crisis has received a temporary stay of execution thanks to massive liquidity from the ECB. However, liquidity delays rather than solves solvency problems and we continue to expect renewed concerns over peripheral debt during the second half of the year.
Increasingly budgets are not just for March, they are planned to incorporate the future with decisions affecting future financial years. This week’s Budget will be no different with weekend press leaks promising an easing of Gordon Brown’s parting poison pill, the 50% tax band, down to 45% in April 2013. April 2013 is also likely to represent the target date for the Liberal Democrats’ cherished target of raising income tax allowances to £10,000. This will provide an important boost for those on low incomes and together with other welfare initiatives will provide a supply side boost to the UK economy.
The Government’s hope is that these politically important initiatives for their respective parties will be funded by improved growth over the next few years. It is effectively taking a down payment on this growth by pre-announcing the moves in the hope that it will boost consumer confidence. For the current fiscal year any spending initiatives must be balanced by higher revenues. The main source of revenue gains will be a crackdown on tax avoidance. This is a time honoured ploy of governments desperate for revenues to attack tax avoidance. The plan for a general anti-avoidance rule aims to ensure a minimum level of taxation on high earners. These funds will be used to increase income tax allowances to £9,000 and to further delay the fuel escalator.
The Chancellor is expected to present two further initiatives to great fanfare and little economic effect. The first is the credit guarantee scheme for lending to small and medium sized companies. These guarantees are contingent liabilities and do not count towards sovereign debt to GDP. This is convenient, but we do not expect the initiative to contribute materially to easing of financial conditions for the sector. UK financial sector balance sheets are still highly leveraged and while the government and indeed the Bank hope that the bulk of this deleveraging will be achieved in overseas markets, further deleveraging of domestic balance sheets is required over the next few years.
The second initiative is the apparent privatisation of a portion of the roads network. This portion is likely to be small, (3-5%) of the network, and is part of the incentive for domestic institutions to finance infrastructure projects. However, details of this plan are sketchy and will need to be fleshed out in considerably more detail before it represents anything more than a deflection to disguise the lack of more substantial business friendly initiatives. They will not be enough, but the lack of fiscal manoeuvrability means that the Government is likely to borrow further from future growth to pre-announce more cuts in corporate tax for 2013 and 2014. They in turn are likely to be financed by presumed revenues from the partial privatisation of the roads network.
The funding implications of this largely neutral budget should be equally neutral for the gilt market, but the government has a cunning accounting trick up its sleeve. It will assume the assets and liabilities of the Royal Mail pension fund, which has assets of £28bn and liabilities of £37bn. The liabilities will disappear from view into the mass of unfunded future liabilities, which the rating agencies conveniently do not take into account because they presume that governments can always renege on their promises. However, the Government can use the proceeds of the assets to lower borrowing next year. We have assumed that the government will spread these proceeds over the next two years with the bulk of the assets, £18bn, being sold in the forthcoming fiscal year.
Together with the £7bn undershoot for 2011/2012, this suggests that the gross funding requirement will be £25bn lower than the Debt Management Office’s December assumption of £189bn at £164bn. The distribution of this funding requirement will be the most intriguing aspect of the budget presentation. The DMO will be grateful for the opportunity to lower the funding requirement from the current year total of £178.9bn and ease the exhausting treadmill of auctions. Having successfully persuaded the Bank of England to crunch the purchase bands of its QE program to bring them in line with the DMO’s own maturity categories, it seems reasonable to assume that the agency will weight its issuance towards short and medium conventional. Issuance in these two sectors will be maintained at last year’s gross amounts of £60.6bn and 39.8bn respectively.
This leaves the £14.9bn savings to be split between long conventionals and index linked bonds. A substantial proportion of the Royal Mail pension fund consists of £10bn index linked bonds. These will be sold onto the secondary market which should help to satisfy pension funds craving for linkers. This provides the DMO with the opportunity to reduce new linker issuance by £5bn to £34bn, which in turn provides the DMO with the opportunity to reduce long dated conventional issuance by £9.9bn to £29.6bn.
The main advantage of this substantial reduction of long-dated issuance is that it creates room for the new ultralong bond. Press reports last week suggested that this could be as much as a 100yr bond. While this has the wow factor for the government, it is likely to be a maturity too far for the perennially risk averse DMO and we expect the maturity to be a more palatable 70-80yrs. However, the 100yr bond speculation is more likely to be a red herring, with the DMO using it as cover to reduce issuance of long conventionals. We expect the DMO to conduct a consultation on the issue first and it may quietly drop the idea in time. More importantly, speculation is based on the low level of average long conventional rates. But these average spot rates are misleading and the forward curve is generally upward sloping at this portion of the curve making it relatively expensive for the government to raise funds in this new sector.
Indeed, the speculation over the 100yr bond may be a cover for the Chancellor to gather further positive coverage for his budget by declaring an end to the War. By retiring the War loan, the Chancellor can finally repay First World War debt and re-issue a new perpetual bond to better serve the longevity requirements of the pension industry.
Chief Economist, Co-Fund Manager
Mar 20, 2012 at 3:53pm