28 Nov 2023
Jonathan Platt, Head of Fixed Income
Jeremy Hunt pulled a rabbit out of a hat last week. Despite saying, just a few months ago, that tax cuts were off the agenda, he managed to find fiscal room for two significant moves.
First, there was a cut in employees’ National Insurance (NI) payments, with the rate being reduced from 12% to 10%. Instead of coming in from the beginning of the next tax year, implementation will be from early January, a clear nod to the upcoming election. This will deliver a boost of around £450 per year on average.
Second, the temporary investment allowance policy, which sees capital expenditure fully charged to profits, has been made permanent. There is a logic to both approaches. The UK has labour market and productivity problems. The NI change will make employment more rewarding and, coupled with more stringent tests for out of work benefits, is an attempt to attract more people back into the labour force. On productivity, the UK has a low level of investment relative to other major economies and the new policy is aimed at encouraging more capital spending.
There remains a question of how to define the reduction in the NI rate. Is it a tax cut? Clearly it is. However, at the same time, tax allowances continue to be frozen. This means that tax revenue is increasing, and rising at a faster rate than anticipated, due to the rapid growth in nominal wages. This ‘fiscal drag’ is significant and is the reason the Chancellor had headroom, courtesy of new Office for Budget Responsibility (OBR) deficit and debt forecasts, to loosen fiscal policy. However, there was bad news elsewhere in the OBR’s forecasts. There were downgrades to the next year’s economic outlook and although no recession is predicted, growth of 0.7% in 2024 is materially lower than previously expected; their growth forecasts, it should be said, are still higher than the Bank of England’s. In the longer term the OBR has marginally pulled back its estimate of the UK’s trend growth to 1.6%.
The loosening of fiscal policy will boost output, with economists pencilling in a 0.2% growth impact next year and the OBR predicting a 0.3% boost over five years if the Chancellor availed himself of the fiscal headroom – which he has. The downside is that inflation may turn out to be stickier and, consequently, interest rates could stay higher for longer. Looking at UK yield curves, the Autumn Statement has contributed to a rise in rate expectations; early last week November 2024 pricing indicated a base rate around 4.5% and this has now moved above 4.75%. It was not solely due to the Chancellor’s policies as survey data was more upbeat, with the UK Composite Purchasing Managers’ Index nudging back above 50.
The gilt market was not impressed. The higher base rate outlook was compounded by disappointment about government bond supply. There were expectations that the fiscal drag effects would lead to a reduction in gilt issuance. However, the OBR sanctioned headroom was allocated to tax cuts, dashing hopes of a cutback in long-dated gilt supply. Yields rose by a pretty uniform 20 basis points across the curve, with 10-year yields ending the week at 4.3%.
The problem for the next Chancellor is that the OBR debt forecasts are based upon future tax raising (is fuel duty indexation actually going to happen?) and tough public spending targets. With certain expenditures ring fenced in real terms, there will need to be severe restraint in the ‘unprotected’ areas. In reality, these assumptions are fanciful; this degree of restraint is very unlikely against a backdrop of already strained public services. That means two alternatives, higher taxation, or greater debt, neither of which is attractive.
There is a third possibility: productivity improves, with faster growth generating significantly higher tax revenue. But the prospects do not look good. Neither NI changes nor capital expenditure write-offs are going to materially change the growth dial over the next few years. Net migration may help raise growth, as the number of potential employees rises, but it also means more claims on public services. I fear that the OBR’s long-term growth forecast is more likely to be further reduced over time rather than increased. The next Chancellor will face invidious choices.
The UK gilt market was an underperformer last week although global yields generally increased. In the US, the Thanksgiving holiday disrupted trading but over the week 10-year yields rose to 4.5% and German yields pushed above 2.6%. The major event in the euro area was the surprise election victory for Geert Wilder’s Freedom Party, indicating higher support for more populist policies in the Netherlands. Dutch bond markets were not too perturbed and 10-year yields remain below 3%. A ‘Nexit’ referendum looks highly unlikely despite earlier rhetoric. But migration remains a big political issue across Europe and is likely to impact politics more broadly, given the demographic profile of Europe relative to Asia and Africa.
In credit markets it was a dull week. Investment grade sterling credit consolidated recent gains and spreads are moving towards the August lows. There is scope for further compression as investors are still over-compensated for default risk but the poor outlook for global growth favours more caution. Our preference remains for credit over government bonds at shorter maturities but the degree of conviction reduces at longer durations. In high yield we have a similar preference for shorter-dated strategies where yields look attractive. Like investment grade credit, high yield had a quiet week, with spreads lower and nudging towards the lows of the year.
This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.