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September 2016 asset allocation team views MACRO For Professional Advisors M AT T E R S Maybenomics - the Bank (of England) and budget boost Following the EU referendum, the UK entered a period of heightened political and economic uncertainty. As the fog begins to clear, we are starting to gain a better understanding of what might be on the horizon for the UK. Hetal is a European economist and is responsible for providing macroeconomic research and forecasts for the fixed income, asset allocation and equity teams. Profile Picture 2 Goes Here (if needed) Emiel joined LGIM in August 2013 as Head of Asset Allocation with responsibility for asset allocation, strategy and macro research. Macro Matters represents the viewpoint of the asset allocation team at LGIM. In our initial post-referendum economic update, we The next key focus for us is what the government will downgraded our forecast for UK economic growth. We do in terms of the budget. Like most commentators, we expected a mild recession but were aware of potential assumed that the government would allow ‘automatic downside risks in an environment of heightened stabilisers’ to work into a period of slower growth – for uncertainty. Since then, our concerns have faded example allowing government spending to increase as somewhat, as domestic political uncertainty has unemployment benefits rise and tax revenues decline. diminished with the quick appointment of a new Prime Minister and a measured approach to EU relations. But with the new Chancellor Philip Hammond saying that the UK can “reset” budget policy if necessary, and On top of this, the Bank of England (BoE) has already delivered the vast majority of what we expected to see from it by year-end. It has cut interest rates, embarked on more quantitative easing by buying both gilts and corporate bonds, and eased pressures in the banking system, which further reduces the risks to the UK economy. Time will tell how the economy will react. the government abandoning their previous objective of September 2016 Macro Matters balancing the budget by 2020, it looks like a significant WHAT OPTIONS DOES THE CHANCELLOR HAVE? government tax cut or spending stimulus is on the cards 1 A VAT cut – this is a real possibility; it would be a quick in the upcoming Autumn Statement. This has led us to and easy measure to implement, and could give a short- revise our UK growth outlook, with better-than-expected term boost to the consumer. We regard a VAT cut as outcomes having now become more likely. likely if the inflation increase from a weaker pound is high (although we are not currently expecting inflation WHAT COULD BE THE SIZE OF THE POTENTIAL BUDGET to jump significantly through this channel) or consumer BOOST? sentiment deteriorates. If the government chooses this The BoE is buying £60bn of extra gilts, which is roughly option, 2% of GDP roughly equates to VAT being cut to 3% of GDP. This buying absorbs the bonds that the 17.5% for 2 years. The downside to this option is that government issues to pay for the deficit. A weaker households might just save the benefit of the tax cut. economy (we downgraded GDP by around 2%) could lead to the government deficit widening by around 1% 2 A corporation tax cut – George Osborne talked about of GDP versus what it could have been otherwise. cutting corporation tax to 15%, but it is already set to fall from the current 20% to 17% by 2020, so this would only This means if the government thought it could increase be a small additional stimulus. spending up to the additional purchases from the BoE, the government could have up to 2% of GDP to play around with. This is not how the government has 3 Other tax cuts – A stamp duty holiday or cuts for firsttime buyers are also possible, although politically this acted previously, as it was focused on returning to a could be difficult if it is seen to be helping higher earners. budget surplus. But the UK Treasury is now under new management. 4 Get busy building – Additional government investment is likely to be more powerful than tax cuts. Typically the economy gets a greater boost per pound from direct spending by the government than from tax cuts. Additional investment could include infrastructure projects, research and development programmes, and increased housing construction. This would be better for the UK from a longer-term perspective, as it increases the country’s productive capacity. The disadvantage is that the impact would be slow to come through into real activity. However, it could help to shore up investment intentions in the private sector. There may also be additional incentives for the private sector to get busy building, such as subsidies for housing construction and special infrastructure bonds. 2 Macro Matters September 2016 WHAT HAVE WE DONE IN OUR PORTFOLIOS? interest rate environment and it could be some time We believe the clearest implication of increased before the BoE presses the ‘hike’ button. The pound is government spending (or tax cuts) for markets could typically more influenced by financial market factors be for the mid-cap sector in UK equities, especially such as interest rates and the BoE’s bond purchases stocks that benefit from infrastructure spending like than economic growth alone. contractors and homebuilders. The mid-cap FTSE 250 equity index sharply underperformed the largecap FTSE 100 following Brexit, and has only partially HIKE recovered this relative underperformance. The FTSE CUT 250 index is more exposed to what goes on at the grass roots of the UK economy, rather than the more international FTSE 100 index, so should benefit from any increase in government spending. With this in mind, we have recently increased our exposure to the FTSE 250 and a basket of equities that benefit from increased infrastructure spending. As our regular readers know, we have been short the pound since the night of the referendum1. Since then the pound has weakened considerably. Although we mentioned 1.25 (versus the US dollar) as the level to become neutral on sterling, we have reduced our short position considerably in the past 10 weeks, taking profit for our clients on part of this short position. We believe that some of the downside risk scenarios for sterling have been removed by recent positive economic data in the UK. Moreover, we understand that a short pound position has become a crowded trade as the consensus expects sterling to weaken in the coming months. This increases the risk of a positioning squeeze. We don’t see the prospect for greater government The window of opportunity for the government is Autumn – we have the Conservative party conference in October and the Autumn Statement by the Chancellor scheduled for 23 November. With that excitement on the horizon, it almost makes you glad summer is over. For the latest multi-asset views from the Asset Allocation team visit our blog. spending as a factor that significantly changes the outlook for gilt yields or the pound. While ten-year gilt yields of around 0.7% are low, they do reflect a very low 1. See what now for the UK and sterling? Macro Matters July 2016. 3 September 2016 Macro Matters CONTACT US FOR MORE INFORMATION For further information please contact: 0345 070 8684* [email protected] lgim.com Important Notice This is not a consumer advertisement. It is intended for professional financial advisers and should not be relied upon by private investors or any other persons. 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