Budget Summary: Osborne Chooses Pearls before SWINE – comment by Stuart Thomson, chief economist at Ignis Asset Management

– Emergency Budget should satisfy two aims: maintaining the UK’s triple AAA credit rating and enabling the MPC to keep base rates at their current emergency level.
– Net fiscal tightening not as great as the austerity proposed by the PIGS of Portugal, Ireland, Greece and Spain – reflects the greater flexibility for the UK economy provided by monetary and foreign exchange.
– Budget bullish for gilts and Sterling.  Sterling has greater potential to rally against the €uro than the US Dollar, where enthusiasm will be tempered by the maintenance of record low interest rates. 

“Chancellor George Osborne has obeyed Rahm Emmanuel’s, Barack Obama’s Chief of Staff, famous maxim; ‘You never want a serious crisis to go to waste. What I mean by this is it’s an opportunity to do things that you could not do before.’ He referred of course to intensifying the fiscal austerity proposed by the previous government in order to rebalance the economy away from unproductive areas of the public sector towards productive sectors of the private economy.
“This can be characterised as choosing the pearls of the private sector over SWINE, where this latest acronym refers to Scotland, Wales, Ireland (Northern) and the North East, where the share of government expenditure is particularly high in relation to the private sector. The government has reinforced this strategy by focussing 80% of the deficit reduction on expenditure cuts.
“Additional plans for fiscal consolidation amount to £40bn per year by 2014/15. £32bn of this saving will come in the form of additional current expenditure cuts, with no further planned cuts in capital expenditure. These current spending cuts will be announced in the Autumn Spending Review, which will be delivered on October 20th.
“A key part of these current expenditure cuts will come from welfare reform. This will include the adoption of the consumer price index for indexation of tax credits, public sector pensions and welfare benefits from next April. The Chancellor also announced a public sector pay freeze over the next two years for public sector workers earning more than £21,000, whilst those earning less will receive a fixed pay award of £250 per annum. £8bn of the additional fiscal restraint over the next four years will come from tax increases, including an increase in the VAT rate to 20% from January 4th 2011.
“This additional tightening represents 2% of GDP over a four year period, and together with the previous government’s target represents a net tightening of fiscal policy equivalent to 6% of GDP. This is not as great as the austerity proposed by the PIGS of Portugal, Ireland, Greece and Spain and reflects the greater flexibility for the UK economy provided by monetary and foreign exchange. The Chancellor reinforced this message by closing the Euro preparation department and promising to maintain the Government’s opposition to joining the single currency.
“The emergency budget should satisfy two immediate aims of maintaining the UK’s triple AAA sovereign credit rating and enabling the Bank of England’s Monetary Policy Committee to keep base rates at their current emergency level of 0.5%. The global shortage of genuine triple AAA assets should help to maintain strong international inflows into the gilt market and prevent the UK from becoming another casualty of the European sovereign debt crisis.
“The Office for Budget Responsibility has won the Office of the Brown Nose for the second week running by predicting that the heightened austerity would only reduce growth by 0.3% to 2.3% next year, while the forecast for 2012 was left unchanged. We have absolutely no doubt that the positive rebalancing of the economy will help support longer-term productive potential and offset the adverse demographic impact of the aging population. It is naïve to assume that the improvement will be instantaneous. As we noted last week, the OBR’s forecast is heavily reliant upon a rapid recovery of corporate investment and export demand. The prospective tightening of fiscal policy in Europe, US and Japan over the next few years suggests that global growth will be significantly weaker than the OBR’s models have assumed, leading indicators have already peaked, and net exports will provide a considerably smaller contribution to growth over this period.
“Likewise, the OBR has fallen victim to the fallacy of spot rates, by assuming that the relatively low level of 10yr spot gilt rates provides a powerful incentive for corporate investment. However, this 10yr spot rate represents an average of the forward rates to this period. The average is anchored by base rates at 50bps, and as the chart of the forward interest rate curve shows, these forward rates rise rapidly from this base. One year gilt yields, projected nine years forward, are above 5%. We do not believe that this is conducive to the investment boom that the OBR expects. We believe that this investment boom will take place, but will be triggered by further quantitative easing from the MPC. This is designed to drive down these forward rates and provide a genuine incentive for record corporate investment. The domestic and global economy, as well as global inflationary trends, will have to slow further over the next year to provide the MPC will sufficient justification to resume QE on this massive scale.
“The emergency budget is bullish for gilts and Sterling. We believe that Sterling has greater potential to rally against the €uro than the US Dollar, where enthusiasm will be tempered by the maintenance of record low interest rates. The budget should reduce the sovereign risk premium for gilts. However, initial enthusiasm will be tempered by the fact that investors had already discounted a fall in gross gilt funding from £187bn to £165bn, and the unadventurous way in which the Debt Management Office distributed these savings across the market sectors.”
These are the views of the author and do not necessarily reflect those of Ignis Asset Management.