UK Budget Fallout and the Big Week Ahead

Next week is going to be a big week for financial markets around the world.

First, we have the US 2024 elections on November 5th. I believe the results will have an important impact on the US market overall and on individual sectors and companies. They will also affect other financial markets, including the Treasury market and arguably gold, the dollar, and cryptocurrencies.

Also next week, the Chinese government will reveal more details on the eagerly awaited fiscal package of measures designed to bolster the economy and help address the challenges in the property market. If the markets like the scale and focus of the measures I would expect another rally in China’s domestic equity markets.

In the UK, the Bank of England’s monetary policy committee meets to decide what to do about interest rates. I expect the committee to cut the bank rate by 25bps, but it will also be interesting to see what the committee makes of the recent budget and its forecast impact on the domestic economy. It will also be interesting to see the Bank’s updated forecasts and compare them with those that were published this week by the OBR.

As the week unfolds, I will try to give you an idea of what I believe are the short- and longer-term implications of these events. It should be very interesting.

Before the week kicks off though, I wanted to give a few more thoughts on last week's UK Budget and the state of the UK markets.

1. Why is the gilt market falling?

Regular readers of this blog may recall a piece I wrote a couple of weeks ago: Popular Myth Massacre. In it, I showed that contrary to widely held beliefs across financial markets, the media and in government, there is no relationship between gilt yields and the size of the budget deficit and no relationship between the size of the UK’s public debt and the economy’s growth rate (over the last 45 years).

For those who haven’t read the piece, I have shown below the two key graphs that illustrate the absence of any causal relationship between these independent variables.

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I went on to show that the principal driver of gilt yields is inflation, which in turn drives official interest rates (bank rates) over which the MPC presides. (The next MPC meeting is next week, and I expect the committee to cut rates at that meeting by 25bps.) For those who might doubt this conclusion, here are two more charts from that blog that show this relationship very clearly.

I have reproduced these charts in part to help inform the debate that is raging in the UK financial markets today. Ten-year gilt yields have risen dramatically since the budget, and many are attributing this to the higher deficit numbers announced in the budget speech, which, of course, means higher government borrowing and gilt issuance. However, yields are rising, I believe (see above) because buyers and sellers of gilts are making a judgement that the budget’s inherently expansionary fiscal consequences will lead to higher inflation.

This is a mistake for several reasons.

For example, in my judgement, the higher costs businesses confront as a result of the increase in employers NI will be offset by adjusting their direct and indirect labour costs down rather than by pushing prices up. This will mean lower wage rises next year than we would have seen absent these changes, and this will have direct disinflationary consequences along with the further reductions in energy prices and significant base effects, which will further reduce inflation in 2025. These factors will significantly outweigh the potential inflationary consequences of higher government spending.

Consequently, I expect this kerfuffle in the gilt market to subside as it did back in 2022 following Liz Truss’s planned fiscal measures.

2. “Invest, invest, invest”

Rachael Reeves’ political narrative was very focused on the desire to invest, principally in public services, and, as a result of that increased government investment, drive higher growth in the economy. Unhelpfully, the OBR has decided that this additional government spending (investment) will not lift the growth rate of the economy over the forecast period (next five years). In fact, the OBR has very marginally reduced its growth forecasts from those it updated earlier in 2024 following the previous administration’s last budget (see below).

I must confess that I haven’t read the OBR’s Economic and Fiscal Outlook (October 2024), but much of it is devoted to quantifying the implications of the government’s significant increase in spending. Here is a great chart from that report, which summarises the outcomes of the changes announced yesterday in the fiscal year 2028/29.

In summary, the UK economy will have higher government spending, taxes, borrowing, and public investment but not higher growth, which is forecast to average 1.75% over the five-year period, lower than the average of 2% between 2010 and 2019. Apart from shining a rather bright light on much of the budget politics about recent UK economic history, this forecast outcome is concerning but not necessarily surprising.

It is concerning because all the extra spending is not expected to lift the economy’s growth rate, but it is also not surprising because, over the last seventy years (1950 – 2019), there has been no relationship between the level of investment spending and growth in the UK economy. Absolutely none. (See chart below)

This may seem counterintuitive and requires some explanation. This chart does not say that investment in the economy is not important; it clearly is, and without it, the economy would eventually grind to a halt. But what I think it does make clear is that the premise so often repeated in this and other budget statements that cranking up publicly funded investment in the economy will lead to higher growth is just false. It may sound good, but it is empirically not true. It appears that the OBR has, by implication, acknowledged this as well.

To be completely transparent, the OBR has said that the additional capital spending will result in an economy that is 1.4% bigger in fifty years and 0.4% bigger in ten. This is hubris on a giant scale, given the OBR’s woeful record on accurately forecasting the economy over much shorter periods, but if it were true, it would hardly be a good selling point for a government trying to convince today’s taxpayers that paying more was justified. (For the record and by way of comparison, on budget day, the OBR increased its 2024 GDP forecast by 0.5% to 1.1%).

3. What would I do?

So, if cranking up public investment won’t lift the UK economy’s growth rate, what would?

As readers of this blog might have guessed, I subscribe to a free market economic philosophy in which governments take responsibility for the things that they are best placed to deliver (defence and education, for example) and leave the rest to the private sector. The private sector is a much better, but not perfect, allocator of resources. Ultimately, I believe in what Adam Smith described as the “invisible hand.”

Bearing this in mind and acknowledging the practicalities and constraints of the prevailing economic and political environment here in the UK, I believe there are many things that Rachael Reeves could have done to lift the UK economy’s growth rate and productivity which don’t require huge increases in spending, borrowing or tax. Unfortunately, none of these initiatives are featured in the budget, and all have been consistently ignored by successive governments. Generally, these measures are described as supply-side reforms, and at the top of my list would be genuine and determined deregulation. In almost every industry I can think of, but most prominently in financial services, health, and construction, excessive regulation clearly stifles entrepreneurialism and crushes productivity, ultimately harming wealth creation, living standards, and growth. A determined assault on clearly excessive regulation would have many immediate and beneficial outcomes but unfortunately, like so many before it, this government exhibits no desire to take on these entrenched interests. As I said in my previous blog, any move to grasp this nettle would require a significant shift away from a post-pandemic political and institutional (Establishment) consensus.  

Perhaps the biggest single issue confronting the public sector and the nation is the NHS and its complex and intractable challenges. Hitherto, all governments believe that the answer to its problems lies with significantly more financial resources. Meanwhile, the root causes of many of its problems are largely ignored. Successive administrations have been accused of “breaking” the NHS through a lack of funding, which may in part be true, but equally culpable is the damage inflicted on it by the uncontrolled demands of our unhealthy society. Surely, the cornerstone of any credible strategy to improve the NHS and its productivity must start with a determined attempt to address the demand for healthcare as much as the supply.

Summary

The budget was profoundly disappointing, principally because it was yet another missed opportunity. The new administration, which has, in effect, a mandate to be innovative and radical, has instead resorted to tired, ineffective, and broken solutions to the nation’s challenges. Before the Chancellor stood up in the House of Commons this week, she already knew that the institutional judgement of her many measures was a resounding “computer says no”. No change to the economy’s growth outlook despite a huge increase in government spending and a bigger state than ever before in peacetime.

A much better solution to the Nation’s challenges would be for the government to decisively address the economy’s inherent supply-side constraints, deregulate with enthusiasm and look to facilitate increased productivity in the public and private sectors. I hope that a political leader will grasp this nettle with enthusiasm in the not-too-distant future, but I am not holding my breath!

Until then, if you have question about anything happening in the markets this week, drop me an email.