19 Jul 2022
Jonathan Platt, Head of Fixed Income
I have committed to writing a maximum of 1,000 words in my weekly journal. It should take 5-7 minutes to read – so, by the time you finish reading this, the UK will have incurred about £1.5m in additional debt, equivalent to over £5,000 a second.
Let’s look at the numbers. UK government gross debt was £2.4trn at the end of 2021, equivalent to around 100% of gross domestic product (GDP). The good news is that this is quite a bit less than the average debt of the G7 member states. The US, for example, is above 130%. This is the stock of debt, but what about the flow? In 2021, the UK’s government deficit was £187.4bn, equivalent to 8% of GDP. Again, this is lower than the average deficit of the G7 member states, although the fiscal impact of Covid was far greater for the UK than for any other major economy.
In a historical context, the UK government deficit looks manageable, being lower now than at the peak of the financial crisis 2007-2009. And the debt ratio to GDP is nowhere near the levels seen during and after the Second World War. But there are reasons for concern. Unfunded pension liabilities dwarf the amount of government debt, and rising inflation and interest rates will increase the cost of servicing our outstanding debt; the UK has proportionately the most debt linked to inflation. Add in the reduction in revenue that will result from the phasing out of petrol-and diesel-consuming cars and the outlook looks less comfortable.
As interest payments rise, there will be less available for other areas. Defence spending has fallen from 10% of GDP in the early 1950s to 2.5% now. Given the current geopolitical tensions and commitment to NATO, it is difficult to see this falling further. There are three big costs in the UK state: welfare, health and education, and it is not easy to imagine real cuts in any of these. One response would be to raise taxes – but this becomes self-defeating if economic growth stalls as a result. It is an unlikely solution to tax your way out of a deep-seated problem.
Giving the George Medal to the NHS was a recognition of the tremendous vaccine rollout the UK achieved and the dedicated service of its employees through the pandemic. However, this should not disguise hard truths. Our health and care systems are creaking, despite real terms increases in expenditure. An ageing population and rising expectations will add to the strains. A new Prime Minister should look again at what we do – perhaps a new Beveridge Report is required, updated for today’s circumstances? The starting premise of protecting inheritances needs to be challenged.
On the data front, UK GDP for May rose by 0.5%. All three main areas of output rose: manufacturing output up 1.4%, construction higher by 1.5% and services rising by 0.4%. From a growth perspective, it was fortunate that more people visited the doctors in May as this contributed a 0.4% gain in ‘human health and social work activities’. But is this really growth?
So, is a UK recession likely? I think so; pay growth is not keeping up with inflation, consumer confidence is weak, business optimism is falling and the Bank of England will continue to hike rates. Energy prices remain an issue and a further large energy bill increase looks likely for households in October.
In the US, inflation data continued to surprise on the upside with a headline CPI (Consumer Price Index) rate above 9% and core inflation just under 6%. The question now is whether the US Federal Reserve’s next increase will be 75bps or 100bps. Longer bond yields are set for a recession and this explains why US 10-year yields fell on the week. Expectations show that market participants are looking for a peak in US rates at around 3.5% in early 2023, followed by cuts through the rest of the year; by early 2024 the implied rate is now sub 3%. The UK followed a similar pattern, with 10-year yields lower on the week, although ultra-long yields were broadly unchanged.
In credit markets, high yield spreads drifted wider, although still below their early-July peaks. In investment grade credit, a summer lull is developing, although a new issue from Pepsi generated strong demand last week.
Perhaps the national debt hasn’t increased by quite £1.5m in the time it has taken to read this. But let’s be realistic. We need to see productivity growth if we are going to address our problems; without it our services will suffer.
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.