Download Maybenomics – the Bank (of England) and budget boost

September 2016 asset allocation team views
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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.
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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.
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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.
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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.
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September 2016 Macro Matters
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