In the run up to the much-anticipated Budget we take a closer look at the UK’s finances and explore the Chancellor’s options
The UK Budget will be the most important fiscal event in 15 years. Yet the government has not revealed details of the framework under which spending will be decided. Rachel Reeves will therefore announce both new fiscal rules, ambitious investment plans, as well as around £20bn in tax rises to plug the ‘black hole’ in finances.
A messy and complicated budget increases the risks of a market shock. While we see no chance of anything comparable to the Liz Truss mini-budget crisis, UK markets and media are now very sensitive to any hint of fiscal irresponsibility. The key risk is new investment plans that will fall outside the commitment to balance the budget for day-to-day spending. We expect a figure of around £20bn, but if it is much higher, say £50bn, then that could trigger a market shock.
But it’s not all doom and gloom. The UK economy is clearly improving, with rising growth and falling inflation. That is supported by similar positive trends in the global economy, with the US and Europe, our largest export market, also recovering.
Eurozone lags economic recovery elsewhere
Source: Columbia Threadneedle Investments, Bloomberg and Macrobond as at 7/10/2024
Global economic background is positive
Purchasing managers’ indices shows the US growing firmly, the UK next and Europe lagging. However the European consumer is beginning to spend more, which is good news for the UK as they represent far and away the UK’s biggest export market.
US consumers had been spending ahead of their income, pushing the savings ratio down. But recent revisions to the numbers show savings rates back to normal levels, underpinning continued strong consumer spending. This development and a strong US labour market means that recession risks have evaporated. It will also slow the pace of US interest rates cuts.
More good news is falling inflation. Inflation has been close to the Bank of England’s 2% target since April. Although the latest data show a dip to 1.7%, we expect inflation to head towards 3% next year.
There are of course the US elections to consider. But it’s not so much a coin toss as a four-sided dice throw, as control of congress is also up for grabs. A president with a clean sweep, controlling congress, has much more power, especially on the fiscal front. Divided government looks very likely but none of the four possible combinations are reckoned to have a probability of over 30%.
Core inflation falling in the US, less so in UK & EZ
Source: Columbia Threadneedle Investments and Bloomberg as at 7/10/2024.
UK economy steadily improving
The saving ratio in the UK – the proportion of income that consumers save rather than spend – remains close to a record high, so they have the fire power to increase spending. Lower inflation, improving real incomes, should boost confidence and allow spending to increase. Much will depend on what the budget brings, especially in terms of its impact on consumer confidence.
Headline inflation in the UK has fallen dramatically but will likely start rising towards 3% over the next 6-12 months and the Bank of England will be cautious in cutting rates in 2025.
All the evidence suggests that the housing market is recovering. That boosts consumer confidence and also the economy as activity in the housing market picks up.
US were saving less …now they’re not!
Source: Columbia Threadneedle Investments and Bloomberg as at 30/09/2024. Horizontal lines show pre-covid averages.
UK is in a fiscal mess, despite the improving economy
So, with all this good news, how have we got into this fiscal mess? The simple answer is that the accumulated cost of the Covid pandemic combined with higher interest rates. Total government debt is now close to 100% of annual GDP. So, if interest rates are 4%, debt interest alone would give a deficit of 4% of GDP, so to get the deficit down to 3%, which is where it needs to be, we would have to run a budget surplus on the rest.
More economic growth would obviously have helped. But instead, low productivity has made all this a lot worse. It’s been sluggish since the Global Financial Crisis. We are sceptical about the historically unprecedented targets for increasing productivity from the Labour government. However, we applaud the focus on reversing the current weakening trend. Increasing investment is key, but the biggest challenge is in improving government services’ productivity, including the NHS.
Government debt rises to almost 100% of GDP
Source: Columbia Threadneedle Investments, ONS and Macrobond as at 30/09/2024
A messy and complicated budget
No return to austerity underpins Rachel Reeves decision to approve the doctors’ 22% pay award, to increase public sector pay overall by 6.5% and to increase the minimum wage by 5.8%. This will slow the decline in wage inflation. That will also make the Bank of England cautious about the pace of interest rate cuts.
The Labour government has committed to not borrowing for day-to-day spending. That means filling the £20bn or so ‘black hole’ with tax increases. These are to be targeted on the ‘wealthy’ and companies. Ruling out increases of the major taxes will contribute to a messy and complicated budget.
- National Insurance increase for employers. A tax on jobs contradicts other objectives, but is borne of necessity.
- Capital gains tax – last time it was higher it was 28%. That rate was calculated as the then optimum level to maximise tax revenues. So a hike to levels comparable with income tax would be counterproductive in terms of cutting the expected tax revenues.
- Pensions relatively unscathed. This would be a pragmatic decision, reflecting the political sensitivity around pensioners after the heating allowance cut, but also that changes are unlikely to raise significant revenues.
- Inheritance tax is an obvious target, with a number of reliefs likely to be eliminated.
Ambitious investment plans are to be excluded from the government’s rule on funding day-to-day expenditure from taxation. They will be limited by new fiscal rules, but we will only find out details and more significantly, the potential scale of this borrowing with the Budget announcement. We expect a figure of around £20bn, but if it is much higher, say £50bn, then that could trigger a market shock.
UK wage growth falling from high level
Source: Columbia Threadneedle Investments and Office for National Statistics as at 27/06/2024.
