Weekly Digest: Back home

In 1970, the England football team released a single called Back Home before departing for the World Cup in Mexico. It reached number one in the charts. These days it might be an apt title for a single released by ‘non-doms’ and other high earners who are leaving the UK in protest at the increasingly punitive tax regime – although, unlike 1970s football supporters, I doubt many of those left behind will be “thinking about [them]” or “cheering every move”.
Back home is where we return this week as we move to within a month of the much-anticipated Autumn Budget, to be unveiled on 26 November. I’m acutely aware that much of the content of these commentaries focuses on events and markets beyond these shores, for which I make no apology. Global geopolitics, the dominance of US companies and the influence of the Federal Reserve, especially, remain the main drivers of financial markets, not to mention “you know who”.

Furthermore, the UK wealth management industry and self-directed investors are increasingly global in their outlook and portfolio construction, wishing to take advantage of the wider and deeper pool of opportunities available. For example, there’s very little technology exposure in the FTSE 100, which leaves a large gap in access to many of today’s most important trends.

UK borrowing is quite high by historical standards

Public sector net borrowing as a % of GDP

Milestones or millstones?

The run-up to this year’s Budget is almost as drawn out as last year’s, because the Chancellor, Rachel Reeves, has delayed it to late November. It’s no secret that the country’s finances are stretched. With limited prospects that the majority of Labour MPs will support spending cuts, the burden of balancing the books will once again fall on taxpayers.

The extent of tax increases will depend, to some degree, on the state of the economy, although there’s a broad consensus that somewhere above £25bn will be required – possibly more if Ms Reeves gives herself more ‘headroom’ to allow for further fiscal shocks. You might recall that after last year’s Budget we thought the £9bn of headroom she left herself was worryingly thin – and that she might have to return to the tax well despite promising not to do so. And here she is, bucket in hand.

Every piece of economic data released now is viewed through the lens of the Budget. Every milestone passed allows economists to tighten the range of forecasts. So far, the picture is mixed. The public finances for September showed a higher deficit than forecast. The cumulative shortfall of £99.8bn for this tax year is running around £7bn higher than the Office for Budget Responsibility’s (OBR’s) projections – or £13bn if measured purely on the gap between tax income and day-to-day spending. The OBR itself is expected to downgrade long-term UK GDP growth forecasts in its pre-Budget report to the Chancellor, citing weaker trend productivity growth, which will widen the gap even further.

Better news came in the form of September’s inflation data, with the headline rate below forecasts at 3.8% and the core rate unexpectedly falling to 3.5% (figure 1). Because October’s energy price increases were lower than last year’s, the annual rate of inflation should have peaked for now. Reports suggest the Chancellor is acutely aware of the pressure inflation puts on real household incomes. One idea being floated is to scrap VAT on household energy bills. It also makes it less probable that she will raise the basic rate of VAT or extend it to items for which there’s no VAT. The quid pro quo could be higher income taxes and, at the very least, another freeze in tax thresholds.

The latter ruse is a classic example of ‘financial repression’ – government policies that make it harder, if not impossible, for households to keep up with inflation. By its nature, it is also rather sneaky. The OBR calculates that the starting income for paying any tax, which has been frozen at £12,570 since 2021–22 (a policy introduced by the Conservatives), would now be £15,520 if it had been indexed to inflation. The 40% income tax threshold, based on the same premise, should be more than £61,000 rather than stuck at £50,270. That means someone earning £60,000 pays around £2,500 more in tax every year. Sadly, unless the UK can find a way to accelerate growth in the economy’s productive capacity, there will be more of this sort of thing in future.

The latest GDP figures showed that the economy grew 1.3% in the year to August. If inflation continues to fall, that would give the Bank of England some scope to continue cutting interest rates. That would be welcome news, especially for those having to refinance maturing five-year mortgages taken out with rock-bottom rates in 2020. There’s one more cycle of monthly data to negotiate before the Budget. Let’s hope there are no nasty surprises, or those milestones could turn into millstones for the Chancellor.

Inflation cools but pressure remains

UK consumer prices rose 3.8% in September, coming in below forecasts and offering some relief for households. But the rate is still high enough to limit the Bank of England’s room to cut interest rates.

Turning to markets

The FTSE 100 is not a great barometer of the UK economy or politics. That said, it can reflect large movements in the pound because such a high proportion of FTSE 100 companies’ earnings are from overseas. That tends to make a falling pound positive for the index, by increasing corporate earnings in sterling terms. Domestic influences are more visible in the performance of sterling, government bonds and smaller companies with greater UK exposure.

The message from markets is more measured than much of the media commentary, which often carries its own political slant and a tendency towards sensationalism. The pound is relatively steady, although flattered to some degree by underlying dollar weakness as investors diversify their exposure. It has drifted lower against the euro this year, but that has more to do with increased demand for the euro as investors anticipate fiscally driven reflation. Interest rate differentials also play a role. With hopes growing for further rate cuts, sterling looks less attractive to income seekers, but that’s not a structural problem.

The gilt market, along with other sovereign bond markets, has also regained some poise. The 10-year gilt yield is at the lower end of its range for the year, at 4.4%, meaning bond prices have risen recently. There are no signs of alarm among investors – perhaps a reflection of already low expectations. Some analysts are even optimistic that the Budget could act as an inflection point for improved sentiment on gilts if it sets the UK on a sustainable fiscal path, however painful that might be for some taxpayers.

It's also worth remembering that the UK’s fiscal situation, in terms of the gross debt-to-GDP ratio, is better than that of the US, Japan, Canada, France and Italy. Indeed, the only other G7 country with a stronger position is Germany, which is currently embarking on aggressive fiscal expansion. Few governments seem willing or able to impose another round of austerity – just look at the turmoil in France or the government shutdown in the US. This broader picture remains an important context for portfolio construction.

With four weeks still to go until Budget Day, there’s plenty of scope for more surprises and speculation. The Chancellor faces no easy choices, and it will be fascinating to see how much political capital she is willing to spend when her backbenchers are pushing back on one side and Reform is applying pressure on the other.

She has a chance to be Gordon Banks, England’s World Cup-winning goalkeeper, who pulled off what’s sometimes described as “the greatest save ever” from Pelé’s header against Brazil. Or she could channel her inner Peter Bonetti, who flapped hopelessly at Gerd Müller’s winner for West Germany in the quarter-final.