Hammond cancels autumn, but winter is here to stay

Despite widespread calls for fiscal stimulus, the Chancellor confirmed the government will continue with austerity, albeit a little less aggressively.

AUTUMN STATEMENT FRONT COVER

Old policy, new rules

The last-ever Autumn Statement doesn’t fundamentally change our assessment of the outlook for the UK economy over the next five years and beyond. The new Chancellor remains committed to shrinking the budget, but has cast out the restrictive fiscal rules of his predecessor and adopted a more flexible approach that permits some budgetary accommodation should the UK or global economy stumble.

Reneging on George Osborne’s rules shouldn’t worry investors. We have had 12 fiscal rules since 1997, of which 10 have been broken or abandoned. Markets rarely bat an eyelid. Under the new rules, the structural deficit (the difference between government receipts and expenditure adjusted so that it is unaffected by whether the economy is growing or shrinking) will be below 2% of GDP in 2020-21; public sector net debt will fall as a percentage of GDP, but only by 2020-21 rather than in every year from now; and a subset of welfare spending will be below a yet-to-be-announced level by 2021-22. Wriggle room is provided by a revision clause that can be invoked if the economy is judged to be suffering a negative shock.

As we will discuss, Philip Hammond announced a very small fiscal stimulus, equivalent to just 0.2% of the economic output expected between the start of 2017 and the end of the current parliament. This is not fiscal loosening, rather a little less tightening than was previously scheduled. The aim is still to put the public finances on track for a balanced budget shortly after the current parliament ends. According to the Office for Budget Responsibility’s (OBR) forecast, the amount of ‘fiscal drag’ on the economy in the 2017-18 tax year is set to be the same as set out in March and there will actually be more fiscal drag than anticipated in 2018-19, before some relief in the final year as a number of the stimulus measures are back-loaded. Given that deficit reduction has consistently faltered since 2010 as growth has disappointed, we’ll believe the easing in 2019-20 when we see it.

All told, the OBR forecasts that the government will borrow an extra £93bn over the course of the current parliament than it forecast in March, before the Budget. Only £16bn of this is due to net new spending announced this week; the majority is due to changes in the forecasts for economic growth (and therefore government receipts) after the vote to leave the European Union. 

Why didn’t the Chancellor give us more?

If the Treasury accepts that the economy is likely to be weaker, why didn’t the Chancellor increase spending further to spur it through the soft patch? After all, there have been plangent calls for fiscal stimulus from across the political spectrum as well as from economists, business leaders and charities.

Indeed, the UK has more room for manoeuvre than most countries. It has the second-lowest debt-to-GDP ratio in the G7, one of the longest debt maturity profiles and a lower budget deficit than the US and Japan. Sovereign bond investors have a lot more to worry about than a loosening of the UK’s purse strings, particularly if the spending is timely, targeted and temporary.

To answer this, we must cast our minds back to the 2015 general election. After analysing the exit polls and surveys, the consensus among political analysts was that the Conservatives won because the electorate judged them to be the party best equipped to manage the economy with prudence. In short, they won because they preached fiscal tightening. Since then, the outlook for the UK economy has become more uncertain and, as the Chancellor took time to point out, productivity growth, which drives growth and living standards over the long run, has languished. Mr Hammond used the word ‘headroom’ a number of times, so it is perhaps unsurprising that a government with this mandate declined to ease back meaningfully on austerity. Its fear being that, if Brexit were to detract more significantly from growth than anticipated, it would end its term with a larger deficit than it started with.

New, more uncertain forecasts

Public borrowing has not fallen to the extent forecast in the March Budget. Public Sector Net Borrowing (excluding government-owned banks) declined 10% between April and October relative to the same period last year, yet the Budget was based on a 25% fall in this fiscal 

year. This now seems well out of reach: the OBR now projects that borrowing for 2016-17 as a whole will be £12bn higher than forecast in March. This could quite easily be higher still. While we still do not expect the vote to leave the EU to precipitate recession, our five preferred survey-based leading economic indicators of business, investment and consumer activity all point towards a significant slowdown – possibly to the point of stagnation – in the first quarter of 2017.

Of course, Brexit makes forecasting the public borrowing requirement more difficult than usual. Once the UK stops making and receiving contributions to and from the EU budget, the public wallet will be better off to the tune of 0.4% of GDP a year. However, the government may want to replace many of the EU subsidies with its own measures – a British Agricultural Policy, for example. Such policy outcomes are unknown even to the government itself.

Furthermore, the leave vote could lower government receipts (for example, if uncertainty delays or derails private investment or sterling weakness causes the price of non-substitutable imported goods to rise, lowering consumer spending on domestic goods and services). The majority of independent forecasters, including ourselves, suggest this will be the case: the average forecast for growth in 2019 collected by the Treasury has fallen to 1.6% from 2.1% in May (although the OBR has continued to use 2.1%, which arguably increases the risk of missing the targets). The dispersion of estimates has also increased, necessitating further prudence from a Chancellor intent on shrinking the deficit. According to the Institute for Fiscal Studies, if the economy was just 1% smaller than forecast by 2020, borrowing would be at least £13bn higher. 

Addressing the ‘productivity gap’

The Chancellor set out a public infrastructure programme designed to arrest the deterioration of UK productivity relative to that of other developed economies. According to figures released by the Office for National Statistics earlier this year, output per hour in 2014 was 18% below the average for the rest of the G7 economies – the widest ‘productivity gap’ since comparable estimates began in 1991. The UK is 30% less productive than the US, meaning that the average American worker can achieve in three hours what it takes a UK worker to achieve in four. This is clearly concerning: in the long-run deteriorating relative productivity lowers the exchange rate and will result in lower real wage growth relative to our peers, which could cause our most talented workers to emigrate to countries with better prospects.

The £23bn National Productivity Investment Fund is certainly a step in the right direction, albeit rather small at just 0.3% of GDP. Remember that Mr Osborne cut public investment to the lowest level since the 1990s. Earlier this year the International Monetary Fund urged all countries to adopt policies that would increase spending on research and development by 40% in order to raise productivity and improve welfare. Presumably it would encourage those countries that have fallen behind in productivity to do even more? The additional funding announced for this parliament increases total R&D by just 2.3%. Tax breaks on R&D would be better, and, as we wrote in our Brexit analysis, could help to capture the significant foreign direct investment multinational firms are planning in the area, offsetting some of the costs of withdrawing from the single market.

Other measures with equity market implications

In response to one of the most emotive issues among millennial voters, the Chancellor committed to providing an additional £1.4bn to deliver 40,000 affordable homes on top of the 200,000 already scheduled. However, this is little more than a sop, amounting to just £35,000 a home (presumably the private sector will be called upon for the rest?). This still falls well short of an increase in supply that is likely to dampen house prices. That said, sky-high house price-to-rent and price-to-income ratios make it unlikely that prices will continue to grow at anything like the pace of the last decade.

The government infrastructure initiative is targeted regionally across the UK and the £23bn is designed to be spent over the next five years, providing employment as well as new road and rail links to boost economic growth after Brexit. In the near term, the beneficiaries will be contractors and building materials companies.

Over the last few years, in an effort to diversify their business models in the fast-changing internet age, the leading estate agents have moved more into short-term lettings. Signing-on fees have been described by many as indefensible in the current environment, so it is no surprise the government has sought to ban them. The impact on profits will be small as most of the letting revenues come from the fee the landlord pays to manage the property, so Wednesday’s share price reaction seems excessive.

The above-inflation increase to the national living wage to £7.50, which applies to workers over the age of 25, is actually slow progress towards Mr Osborne’s target of £9 by 2020 and shouldn’t come as a surprise. Nevertheless, some low-wage employers – in the pubs and restaurant sector, for example – are already blaming profit shortfalls on wage inflation. Indeed, our wage model continues to suggest that there is plenty of upward pressure on wages in the pipeline as the economy reaches full employment and surveys report skill shortages and fewer people looking for additional hours. Focusing on companies with pricing power – the ability to pass on increases in costs – is essential in this environment.

Bond yields and the baton of monetary and fiscal stimulus

Globally, many investment strategists expect loose monetary policy to hand over to looser fiscal policy next year, and forecast that bond yields will continue to rise accordingly. We believe that political constraints are more binding than many believe and the Autumn Statement only adds to this thesis.

While many are excited about President-elect Donald Trump’s promised fiscal splurge, we believe that the fiscal hawks in his own party will delay and ultimately water down his proposals considerably. Meanwhile, the European Commission last week released an overlooked paper, Towards a positive fiscal stance for the Euro area. Although this sounds positive, it made it clear that only countries abiding by the Stability and Growth Pact (i.e. with budget deficits no greater than 3% and debt less than 60% of GDP or “diminishing at an adequate rate”) should undertake any fiscal easing. This leaves only Germany, whose council of economic advisors judged earlier this month that such action could cause inflation to overheat.

We believe that bond yields will be driven by commodity prices, currency and the need for more quantitative easing in Europe – which will be dictated by next year’s politics. All of these are notoriously hard to predict, and we encourage investors not to get carried away with trades predicated on bond yields continuing to rise and yield curves continuing to steepen. Many stocks and sectors have already moved sharply relative to the rest of the market. As the Chancellor underscored, uncertainty still prevails, and quality, cash-compounding companies with strong returns on equity are likely to continue to offer the best risk-adjusted returns.

By Edward Smith, Asset Allocation Strategist, and Julian Chillingworth, Chief Investment Officer.

Financial planning implications: Taking a long-term view

Mr Hammond’s decision to move to a single policy announcement each year – an Autumn Budget, months before the start of the new financial year – will bring welcome stability and emphasises the importance of long-term planning rather than the latest tax planning fad.

It wasn’t a full-blown Budget, so financial planning details were light, but there were some clear indications of Mr Hammond’s future approach. For example, he pledged to continue Mr Osborne’s work to increase the personal allowance thresholds to £12,500 before you pay income tax and £50,000 before you pay the higher rate by the end of this parliament.

The statement highlighted the need for longer-term planning – better infrastructure, higher productivity and a narrower prosperity gap between London and the rest of the country. Such long-term thinking is not just for the government, but will also help your financial planning.

When coupled with numerous tax changes, stock market volatility over the past few years has created a micro financial planning culture. Clients have sometimes focused on the detail at the expense of the key principles of financial planning. By taking advice and a holistic view of your wealth, your overall financial health will be much brighter. As ever, we would recommend you assess your needs, set objectives, put a plan in place and review regularly.

Financial planning isn’t only about investment strategy or tax planning, but ‘big picture’ questions like “When do you want to retire and how will you fund it?” or “If you were to fall ill, how would your family cope?” These can be much harder to answer than choosing between UK or emerging market equities, yet can have a bigger impact on your long-term financial health. Constructing a financial plan may involve the rest of your family or a business partner. It may be a cliché, but every plan will be different.

The government’s need to generate income has increased its focus on tax avoidance and evasion, which reminds us that paying tax is a legitimate part of life. As ever, tax evasion is illegal, but there are myriad tax avoidance schemes and it is these to which the government will turn its attention. By 2021-22, the government forecasts additional tax revenue of £450m by increasing its counter-avoidance activity and taking more legal action.

Mitigating tax is perfectly legal and is encouraged by the government – anyone who uses their pension or ISA allowances properly is reducing their tax liability and thereby increasing their overall rate of return. But Wednesday’s announcements, as well as recent HMRC action on film company investments, for example, show that the government is emphasising the spirit of tax laws as much as the letter. Existing plans may need to be reviewed.

The statement also suggests there will be more considered changes rather than headline-grabbing announcements. It highlights a number of areas where the government will consult on the details of possible changes, such as the reduction in the Money Purchase Annual Allowance (the amount you can contribute to a pension after you have taken pension benefits), the treatment of salary sacrifice schemes and changes to National Insurance. Our suggestion is not to base your financial planning on a single strategy. Your approach might be legitimate at present, but if it is not in the spirit of the tax system, the likelihood is that changes will be made in the future which may have an impact on your long-term financial planning.

In summary, this is an opportunity to take stock of your financial planning. Rather than worrying about a last-minute change in pension rules or the latest version of the ISA, for the first time in years you have the opportunity to sit down with your financial planner and take a considered look at your objectives. Investing time now will bear financial fruit in the future.

By Christopher Bartlett, Financial Planning Director in Newcastle. If you have an IFA, please discuss the issues raised here with him or her.

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If you would like further information, please contact us on 020 7399 0000 or email info@rathbones.com

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