Budget round-up

In my day job, when called upon to provide commentary for clients, I essentially face two choices: Either inform them as quickly as possible, sure in the knowledge that you are not going to cover all bases, or provide the most in-depth piece looking behind the data for things that are not obvious at first sight. It is a difficult trade-off, particularly when you know that your better-resourced competition is capable of producing in-depth analysis at speed.

Analysis of the UK budget always falls into the category of issues where you know that there are nuggets waiting to be mined but if you spend too long looking for them, the commentary will soon be out of date. After all, the volume of material available online once the Chancellor’s speech has finished is huge. The OBR’s Economic and Fiscal Outlook is a guide to all aspects of the UK macro economy that you would ever need to know (and many that you didn’t). It is all a far cry from the days when the best we could do was run down to one of London’s mainline stations to pick up a copy of the Budget Red Book.

With some hours having passed since Philip Hammond presented his parliamentary statement, did I discover anything obvious that I missed? Nothing really springs to mind, although one nugget which jumped out at me after having looked through the EFO  was Box 2.1 on pp27-28 which highlighted that real GDP in 2012 is today assessed as being more than 2% higher than was measured at the time (see chart). This matters because the starting point against which forecasts were made five years ago was better than anticipated and goes some way towards explaining why the deficit in recent years has come down so sharply.

Turning to the overall content of the budget, much has been made of the significant downward revisions to the GDP growth forecasts, which constrain expected revenue growth and mean that the deficit at the end of the forecast horizon (extended to 2022-23) is projected at 1.1% of GDP versus 0.7% in March. So it’s been revised up a bit? So what? As I pointed out in a recent post, what really matters is debt stability and both the OBR’s and my own forecasts suggest that the debt-to-GDP ratio is likely to start falling in the next year or two. I would in any case be tempted to treat the significant downward productivity revisions with a degree of caution. It may not take much to persuade firms to slightly raise their capital investment and thereby substitute capital for labour, which may make the overall labour productivity figures look better. As the data revisions example shows, if current data are not measuring the true state of the economy accurately, this introduces major uncertainty into the fiscal projections.

Digging through the Budget Red Book, Table 2.1 suggests that today’s fiscal giveaways total £25bn over the period to 2022-23, with spending increases of £18bn and tax cuts of £7bn. Of the measures announced today, 30% is accounted for by additional NHS spending and a further 37% by measures to boost affordable housing. Almost a quarter is accounted for by pre-announced (but not costed) policy decisions and a further 12% from Brexit-related spending. The net effect of the remainder is small change. It all feels a bit underwhelming. Moreover, Table 2.2 indicates that £19bn will be clawed back from measures announced in previous budgets (with most of this occurring from a change in the discount rate applied to public service pensions). Thus the net effect of the fiscal plans announced today is minimal – £6bn over the next five years is peanuts – and clearly policy is not as bountiful on the surface as it appears.

This brings us to the politics of the budget. If the Conservatives hoped to deliver a big bang to impress the voters, they are going to be sorely disappointed and if Philip Hammond’s position was insecure ahead of the budget, I don’t see how it can be much more secure now. But it was the best he could deliver given the constraints under which he was operating. It is not the big bang package his party wanted and arguably he could have done more. Indeed, by pursuing the policy of corporate tax cuts and refusing to uprate fuel duties in line with inflation, there is some low-hanging fiscal fruit to be picked if he is serious about closing the fiscal gap. But to the extent that this budget was about trying to repair trust after the election, such items will have to remain hanging on the tree for now.

Assessing the strength of the tremors

Earthquakes are the result of long periods during which two tectonic plates rub against each other but are unable to smoothly slide over each other due to geological irregularities. But the pressure finally builds up sufficiently to force one plate to slide over the irregularity with such force that it releases energy in the form of a quake. They are generally unpredictable in terms of their timing and the impact of their devastation. But the forces triggering them take a long time to build – indeed, one could be forming under your feet right now.

So it is with economic events and today we have seen a couple of minor tremors which could be the prelude to a much bigger event. Let’s start in Germany where talks to try and form a coalition government finally failed yesterday after two months of fruitless negotiations. There are now essentially three options on the table: form a minority government; form a grand coalition with the SPD or call new elections. Chancellor Merkel does not appear keen on a minority government and the SPD apparently are not willing to repeat the experience of the legislative period 2013-17 when they were accused of being the CDU’s lapdog. And the option of new elections is not palatable to anybody, although Merkel sees it as the least worst option. Indeed, the shock triggered by the September result might cause those who voted AfD as a protest to rethink their strategy because it simply leads to more political chaos. There again, they may not.

Having negotiated the Dutch and French elections earlier in the year, the irony would be if Germany were to become the primary source of political instability with Angela Merkel’s credibility dented beyond repair. It is bad news for two reasons. First, for the euro zone. Having helped steer the euro zone through an existential crisis, Merkel is perceived to be critical to attempts to keep the region on track. Indeed, in Emmanuel Macron she has a political partner across the Rhine who has the vision and energy to kick start Franco-German co-operation. But like other European countries which have turned in on themselves in a bid to address domestic dissatisfaction, a large swathe of the German electorate voted for the AfD in protest at Merkel’s policy of opening the gates to thousands of immigrants. Even assuming she remains as Chancellor, Merkel cannot blithely dismiss this constituency, suggesting she may be a bit too preoccupied in future with domestic issues to fully focus on the euro zone.

It may also be bad news for the UK as it seeks to push forward with Brexit negotiations, for precisely the same reasons. A German Chancellor who is understandably more worried about domestic developments will be less focused on a problem which is perceived across the EU27 as a self-inflicted wound. Moreover, there still appear to be those on the UK side who believe that getting Germany onside will be sufficient to help them get what they want. This was always a naïve view – after all there are 26 other governments with a vote. But if Merkel is less willing, or able, to push through a Brexit deal it removes a crucial weapon from the British armoury.

A second tremor today was the announcement that the European Medicines Agency and European Banking Authority are set to leave London for Amsterdam and Paris respectively. This is the Realpolitik of Brexit in action. For a quick overview of why the loss of the EMA is a big deal, this Twitter thread is worth a read. Recall that in April, Brexit Secretary David Davis would not accept that the two agencies had to leave London even though it was clear that the EU had already begun the process of finding a new home. And lest we forget, banks have not yet moved people out in great numbers – but move people they will over the next 15 months, despite the smug proclamations of those who think the world will remain the same as before. Indeed, for anyone who believes that Brexit is broadly leaving the UK unscathed, it should be noted that the economy is growing only at a rate of 1.5% per annum compared to a rate around 2% prior to the referendum – and that is despite an economic pickup in continental Europe.

Neither of the tremors we have experienced today bode well for the future of Europe in general and the UK in particular. Sometimes, of course, preliminary tremors never result in the big earthquake – as residents of San Francisco over the last 100 years can testify. But they should be treated as a warning sign that there could be worse to come. In the UK case, you can bet on it.

Fiscal constraints are mainly political

With days to go before the government unveils its Autumn Budget, the newspapers are full of the various wheezes that the Chancellor might adopt in order to keep borrowing down whilst simultaneously addressing the key areas that fiscal policy is expected to tackle. As if the economics were not daunting enough, the Chancellor is unpopular amongst large swathes of his party who view his calls for a soft Brexit as a form of heresy. Indeed, were it not for the fact that the Conservatives were decisively weakened at last June’s election, the generally accepted narrative is that Philip Hammond would have been sacked in the summer – partly for Brexit-related reasons but also because of his bungled handling of the proposed rise in national insurance contributions for the self-employed in March.

Hammond’s task is unenviable. The Conservatives are looking to him to provide a fillip to a government which is struggling to regain momentum, but if he gets it wrong his political stock will fall further. The three key areas which he is expected to address are austerity, the thorny subject of public sector pay and a lack of housebuilding. In effect, the latter two are branches of the first and go to the heart of the government’s strategy over the last seven years. Over this period, total government spending has fallen by more than 5 percentage points of GDP – there has not been a squeeze like it since the early-1990s, and even that reflected the rapid pace of nominal GDP growth.

But there is an increasing sense that public sector services are struggling to cope. Although the NHS has been ring-fenced from the worst of the cuts, outlays are not rising fast enough to cope with the changing composition of the population; concerns are mounting about the lack of funding for the police and fire brigade (something I touched on here) and education remains a major bugbear for all political parties. In addition, the squeeze on public sector pay, which was frozen for two years in 2010 and has been capped at 1% per year since 2013, has demoralised staff morale and evoked sympathy from the British public which is generally supportive of the public sector workers on which it relies. Meanwhile, there have been calls for additional borrowing to fund a public sector housebuilding programme to alleviate shortages, and reforms to a university student funding model which requires them to load up on debt now and pay it back over a period of 30 years.

All of this is taking place against a backdrop of a plan to broadly balance the budget by 2022 (although the Conservatives admitted in their election manifesto that it is unlikely to happen before the mid-2020s); the UK’s poor productivity performance – likely to be revised down by the OBR on Wednesday – which will increase the fiscal headwinds, and Brexit. Not only is Hammond’s task unenviable – it is frankly unachievable under current circumstances. Up to now, he has operated within the constraints set by previous Chancellor George Osborne, whose mantra of deficit reduction at all costs was misguided (as I never tire of pointing out). But now he has the opportunity to redefine the fiscal agenda.

First and foremost, the balanced budget agenda should be ditched for it serves no useful economic purpose. Moreover, the nonsense of talking about fiscal aggregates in monetary terms should be downgraded. The howls of tabloid outrage every time a figure in the millions – or even billions – is discussed should be set against the fact that the value of economic output is in the trillions. Furthermore, if the government is concerned about how the market perceives fiscal credibility, the focus should be on debt and not so much the fiscal balance. In simplistic terms the debt-to-GDP can fall, even in the presence of a small primary deficit, so long as the rate of nominal GDP growth is higher than the interest rate on debt. Admittedly, the government has more work to do here as it struggles to stabilise the debt ratio which, on the standard Maastricht criteria basis, is just shy of 90%. But the rate of increase has slowed and debt stabilisation is possible in the next year or so.

There is certainly no sign that the debt market is concerned about UK public finances which, let us not forget, show the deficit-to-GDP ratio just above 2% compared with almost 10% in fiscal 2009-10. Indeed, the interest rate on the benchmark 10-year gilt is currently at an unprecedented 1.3%. There is thus scope to loosen the purse strings a little. I further maintain that the plan to cut the corporate tax rate from 20% today to 17% by 2020 puts an unnecessary hole in the budget balance which could alleviate the strain on critical public services (it is estimated to cost just over £7bn in lost revenues).

A bit of fiscal largesse might go some way towards lifting the gloomy national mood which is reflected in our polarised society (rich against poor; young against old; Leavers against Remainers). Brexit will also change the calculations. Contrary to what the Leavers told us, any fiscal savings from leaving the EU will likely be more than swamped by the long-term impact on revenues resulting from slower growth. I suspect the Chancellor knows this but given the political constraints imposed by his own party, there is little he can do about it.

No steps forward, two steps back

As politicians go, I have a lot of time for former Chancellor Ken Clarke. Anyone who can survive the rudderless Major government of 1992-97 with their reputation intact, never mind enhanced as in Clarke’s case, is a person of substance. Clarke is also a prominent Remainer, who described himself on a Twitter account as a one-nation Tory. He is, in other words, an old-fashioned centrist who is loyal to his party but is not averse to working across party lines on issues of major importance. Indeed, Clarke was the only Conservative MP to vote against the bill triggering Article 50. This is ironic, since his constituents voted to leave the EU in last year’s referendum whereas many of his party colleagues represent areas which voted Remain yet who still voted to initiate the Article 50 process. If you are half as confused as I am by the “will of the people” argument, then I am twice as confused as you.

I had originally planned to quote some of the latest tweets from Clarke’s Twitter account but the account has been suspended, which has to raise questions as to whether it was genuine (pace this week’s big debate about whether fake tweets from Russian bots had undue influence on the Brexit referendum). Nonetheless, the sentiments expressed on the account sounded sufficiently Clarke-ite to bear repeating. One thing particularly caught my eye, which was that although many people have significant reservations about Brexit, including many MPs, the government is committed to the process. It cannot easily be stopped, however much we might wish that were the case. But that does not mean that Conservative MPs should not oppose the most egregiously stupid parts of the process.

As the EU Withdrawal Bill enters the committee stage, with MPs able to table amendments to the original bill, we are now beginning to get a more clear idea of who is opposed and what they object to. As an aside, it should be noted that twelve months ago, this piece of legislation was designated as the Great Repeal Bill which was originally designed to transpose EU law into UK law whilst giving government the powers to strike out those bits they deem inapplicable. Easy, right? Except for the fact that the process is far more complicated in practice, and there is also the small matter of parliamentary accountability. As currently envisaged, the bill gives government the power to strike out EU laws without parliamentary scrutiny (the so-called Henry VIII clause) which rather makes a mockery of the claim that the British parliament will once again take control of British laws.

Having decided on a more prosaic name for the bill, the government is finding it tough to keep its legislative process on track. Brexit Secretary David Davis has promised that MPs will be given a vote on any final deal agreed with the EU. Whilst that is a concession relative to what was originally proposed, it is meaningless, particularly in view of Theresa May’s promise to put the exact time and date of the UK’s departure from the EU into the bill. For one thing, Davis offers only a take-it-or-leave-it vote, so if MPs reject the plan, the UK will leave the EU without any deal, which would be crazy. Second, if the negotiations go to the wire then MPs will not have the opportunity to consider its content before the proposed deadline. As many MPs, including Ken Clarke, pointed out this reduces the government’s flexibility with regard to dealing with any last minutes hiccups. Better to delay a week or more to allow for more discussion than maintain an artificial deadline simply for the sake of political pride.

With 15 Conservative MPs apparently prepared to block the insertion of the specific date into the bill (or, as the Daily Telegraph would have it, "mutineers"), it is likely that the parliamentary process will be far slower than the government initially expected, and the committee stage may not be completed by Christmas as planned, which could delay its passage into law beyond next spring. Under normal circumstances, the sensible option would be to allow more time for these complex negotiations to take place. But time is the one thing the government does not have. Indeed, we have just gone past the halfway point between the date of the referendum and the proposed EU departure date, and it does not feel that we are much beyond the wish-list phase.

Ironically, Manfred Weber, the German MEP who heads the European People's Party Group in the European Parliament and is an ally of Angela Merkel, today held meetings with Theresa May and David Davis and declared himself “more optimistic” about the possibility of reaching agreement with the UK than before (which I assume means she has offered more money). But he also said “the whole idea of building up the European Union, which was supported by the British governments … was to make the lives of European citizens better. We are destroying some of the things that we achieved already. We will regret it … It is a shame there is not the will to stay together.”

I happen to believe he is right, particularly when Politico reports that the UK will at best be offered a basic Canada-style trade deal on exit, and not the broader bespoke deal that Theresa May hoped for – a view which I have heard from another senior EU policymaker in the course of a conversation this week. Indeed, the same person said that a Norway style deal would not work for the UK, given the complexity of the British economy, and since a Swiss-style deal was never going to be on the table, it’s Canada or nothing.

But the most galling part is that the government does not have a coherent plan on how to leave the EU, let alone how to deal with the aftermath. It is car-crash politics, and diminishes the UK by leaving it economically weaker and politically more isolated. But sometimes the only way people learn is through their own mistakes. Unfortunately we all suffer in the process.

It's very quiet out there

As UK political uncertainty mounts, it is striking that sterling-denominated assets have held up reasonably well of late. Sterling has traded in a relatively narrow range over the past year with the trade weighted index registering a high of 79 in May and a low of 74 in August. Surprisingly, investor net speculative positions in sterling, which were heavily negative early this year, have now turned flat to slightly positive. This reflects the fact that FX investors are currently not expecting a significant sterling collapse, although the timing of the move does appear to be correlated with changes in the market’s position on BoE rate hikes. Meanwhile, although the FTSE100 has trailed indices such as the Eurostoxx  50 year-to-date, they have moved broadly in line since May and the FTSE has managed a year-to-date return of 3.8%  – not great when set against other markets but nonetheless positive. Moreover, the weakness of sterling tends to be a positive factor for UK equities given how much revenue is booked in foreign currencies (around 70%).

Thus, political uncertainty appears to be conspicuous by its absence so far as markets are concerned, which reflects the fact that investors are looking through all the rhetoric and concluding that the likelihood of a cliff-edge Brexit is low. Since we are still more than 16 months away from the expiry of the Article 50 negotiation phase, markets take the view that there is no sense in panicking now – there will be plenty of time for that later. Nonetheless, the closer we get to the deadline without agreement, the greater the likelihood that assets will come under pressure, but that is probably a story for next year.

To get a sense of how the market and economic agents assess uncertainty in the UK at present, I constructed an uncertainty index based upon eight variables: (i) FTSE100 equity volatility; (ii) EUR/GBP FX volatility; (iii) GBP/USD FX volatility; (iv) the Baker, Bloom and Davis policy uncertainty indicator; (v) GfK survey data for expected consumer finances; (vi)  expected unemployment and (vii) expected economic situation. The final component is (viii) the CBI’s estimate of uncertainty as a factor limiting capex. Furthermore, if we strip out the equity and currency vol measures, we have a five variable index of domestic uncertainty.

The chart suggests that the aggregate uncertainty index has dipped back close to its long-term average (2000-2015). Whilst the domestic indicator has not fallen quite as sharply, it is well below its summer 2016 highs with only the Baker et al policy uncertainty index showing any extended deviation. The interesting thing is that this policy uncertainty index is based on an online trawl of newspaper websites looking for various keywords which express uncertainty. To the extent that much of the concern expressed about Brexit has indeed come via the media (not to mention the blogosphere, so I am as guilty as anyone), it highlights the noise inherent in the debate without necessarily shedding much light on how the economy is performing. Indeed, many of the other indicators normalised very quickly, which suggests that most economic agents generally got on with life in the wake of the Brexit vote.

This does not mean to say that everything will remain so quiet. The GfK survey data point to a deterioration in expectations for the future economic situation with sentiment now back at levels last seen in spring 2013. Moreover, with inflation beginning to put the squeeze on consumers, we are starting to see some deterioration in expectations for consumer finances.

It is worth noting that the indicator is not a good predictor of longer-term trends. Even in the early months of 2008, when there were signs that trouble was brewing in the banking sector and the economy was losing some momentum, both the aggregate and domestic uncertainty indices remained at low levels. A lurch towards the cliff-edge of Brexit could change perceptions quite markedly. Perhaps UK consumers and corporates need to hurt even more before they realise the potential economic consequences of Brexit. This is why just looking at the current relative stability of the uncertainty index is not necessarily a good guide to future trends. In my view – and that of most of the economics profession – a number of senior British politicians do not seem to understand the risk they are taking with the wider economy. It is incumbent upon them to get it right or the electorate may be in a less forgiving mood than it has been of late.