The chancellor of the exchequer Rachel Reeves has put much store in her growth plans, which have been promoted as a key government economic policy.
But these plans have seriously hit the rocks leaving a confused picture for investors in the process.
Lacklustre business sentiment suggests that a much lower figure is likely, with the Bank of England revising down its real GDP growth forecast for this year to 0.75% from its previous estimate of 1.5%.
This doesn’t bode well for Reeves.
All eyes will now be on the Office for Budget Responsibility’s (OBR) release of its updated economic and fiscal forecasts on 26 March.
The OBR’s fiscal outlook plays a crucial role in shaping government’s policies and could have a negative impact on the gilt market.
For investors that could be a case of déjà vu, with the aftermath of then chancellor Kwasi Kwarteng’s mini Budget in September 2022 causing mayhem in the gilt market.
Although there are no expectations for things to get that bad: at least not yet.
“We could see a bumpy time in the gilt market in the run up to the OBR’s latest assessment of the last budget on 26 March,” said Daniel Casali, chief investment strategist at boutique asset manager Evelyn Partners.
But should the UK’s growth outlook be revised down then the expected fiscal position would also weaken.
To complicate matters, the chancellor’s self-imposed fiscal rules require that the Budget of day-to-day spending, excluding capital expenditure, to be balanced by 2029/2030 and for the targeted net financial liabilities ratio – a broader measure of public debt – to decline by the same year.
This constrains any government movement.
There is therefore limited fiscal headroom of just £10bn to meet the balanced budget rule – a key marker for maintaining the government’s fiscal credibility with financial markets.
However, meeting this rule will largely be dependent on the growth outlook.
Fiscal gap
Asset manager JP Morgan estimates that if the OBR cuts its near-term growth forecast by 0.5% for 2024-25 and 2025-26, while keeping an optimistic average growth of 1.7% onwards, it will cost around £17bn.
But if growth in the later years is revised down the fiscal gap could double.
The government also faces other headwinds to meeting its fiscal targets. These include the higher cost of borrowing.
Overall, JP Morgan estimates that if the government wants to deal with the expected shortfall and leave fiscal headroom of £10bn, it will probably need to find savings of around £20bn in the Spring.
Politically, raising taxes may not be an option for the chancellor, as it would go against the Labour Party’s manifesto.
Reeves and the Labour Party have committed to boosting economic growth through infrastructure investment, planning reforms and decentralisation efforts – with institutional investors expected to play a central role.
It remains to be seen whether the chancellor’s proposals to scrap regulatory red tape to drive construction will boost investment, and with it the country’s growth.
Inevitably UK equities could come under some strain within this testing growth scenario – although not all.
“Despite the country’s economic challenges, large cap listed companies benefit more from global growth, as UK multi-nationals generate a significant proportion of their revenues from overseas,” Casali said.
In addition, geopolitical disruptions, such as restrictions on energy supplies, could lead to outperformance in value-focused sectors like energy, where the UK stock market has signi cant exposure.
In contrast, by setting self-imposed fiscal rules and setting out an ambitious growth agenda, the government has created a stress point in the gilt market – always a worrying area for investors and governments alike.
“Should the government be seen to be missing its fiscal rules, it is possible that longer-dated gilt yields could rise to reflect doubts over its fiscal credibility, particularly with foreign investors,” Casali added. “That’s because given that the UK reports a twin Budget and current account de cit, it is heavily dependent on the willingness of foreigners to buy gilts.”
In the last 10 years, foreign purchases of UK debt, mainly gilts, have been largely behind the positive net portfolio inflows. Without these foreign savings, the sterling exchange rate would probably be a lot lower.
However, some good news for gilt investors is that the UK’s fiscal challenges and gilt supply issues are well known, while weak growth and moderating inflation, albeit with some upward pressure from energy and regulated price changes, could encourage lower yields.
Meanwhile, demand for short and medium-term gilts could see a boost if the Bank of England cuts the base rate.
The interest-rate environment is also markedly different. With US inflation slowing, the Federal Reserve is cutting interest rates, which puts less downward pressure against sterling.
“In short, provided inflation does not make a material comeback, gilts could offer some portfolio protection in the event of a recession,” Casali added.
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