Plugging the gap

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Neil Williams (pictured), Group Chief Economist at Hermes Investment Management, reacts to the UK Autumn Statement…

With the UK economy little changed since July’s post-election Budget, today’s Statement was always going to be one for accountants and politicians rather than financial markets. This left economists to pick out the nuances in the chancellor’s aim of plugging an annual GBP20 billion spending gap relative to plans.
 
There were many. But, the onus, as expected, will stay on targeted welfare cuts, which, together with the previously announced higher personal-tax thresholds and a national living wage, he hopes will incentivise more people into work. In hard macro terms, time will tell how this trade-off plays out in sustaining the UK’s impressive growth-momentum.
 
Meantime, with this growth continuing – in spite of the cold winds from China – equities and conventional gilts should welcome the nudging-up of growth projections, and his continuing tenure of the fiscal reins. Admittedly, his changes today involve a net fiscal loosening from here of about 0.2 of a percentage point of GDP, but the extra funding will probably come from Treasury bills.
 
So, let’s not get carried away. The fiscal screw will have to stay tight if he is to hit his target of grinding down the underlying budget deficit and returning ‘to the black’ in 2019/20.  
 
First, the deficit is still high. Even including special items like bank sales, the transfer of the Royal Mail Pension Plan, QE profits and milder inflation and interest-rate assumptions, the near 4 per cent-of-GDP headline deficit for 2015/16 could still be the G7’s widest after Japan.
 
Second, the recovery should have squeezed the deficit more than it has. While the headline deficit falls on better growth, the structural, less growth-sensitive part will fall by less, begging further reform and consolidation.
 
And, only last year is the net-debt-to-GDP ratio expected to have peaked, at 83 per cent – disappointing given real GDP is 7-8 per cent up on its pre-crisis peak. This 83 per cent ratio is more than twice Japan’s was, when Japan limped into a ‘lost decade’ in the mid 1990s.
 
Financing this debt may become more troublesome if the UK has later to deal with the effects of a ‘Brexit’. Logic suggests the unlikelihood of the UK wanting to risk weaker ties with its main trading partner (46 per cent of export value, 53 per cent of imports), FDI forgone, and a diluted relationship with the US. But, if the referendum’s called, the uncertainty may take the shine off equities and the pound.
 
In the event of ‘Brexit’ (our risk case), conventional gilts may benefit initially from the perceived hit to growth. But, this could be short lived, given about one third of the GBP1.3 tillionn outstanding is backed by international investors sensitive to currency and ratings risk. In which case, it’s possible that dealing with a Brexit and a hit to growth may need the BoE to reactivate QE.
 
Which leaves BoE governor Carney’s latest clarification – that the QE stock will be maintained at the current GBP375 billion until Bank rate has been raised to around 2 per cent – looking like a way of extending his policy options, should Brexit occur

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