The Outlook: May 2020 Economic commentary
Dealing with the coronavirus debt legacy
The coronavirus pandemic has generated a lot of uncertainty regarding the economic outlook, but there is one thing we can say for sure: governments around the world will be left with a lot more debt once the crisis has passed. Massive government spending on support for businesses and consumers, along with a collapse in tax revenues, have resulted in a huge increase in borrowing and rising debt levels. The IMF reckons that general government debt among the advanced economies will rise to 122% of GDP this year from 105% in 2019, with the UK seeing a rise from 85% to 96%.
Talk is already turning to how the debt will be paid for, with speculation rife regarding a renewed period of austerity and/or increases in taxes. A recently leaked Treasury document anticipated that, under a base case scenario, the UK’s budget deficit would rise to £337bn this fiscal year compared to £55bn forecast in the March budget; budget cuts of £25-30bn would be needed to fund the increased debt.
The document went on to outline a menu of measures to make up the shortfall: a two-year freeze on public sector pay could generate savings of £6.5 bn by 2023-24; an end to the state pension ‘triple lock’ would save £8bn a year etc.
How likely is a renewed period of spending cuts and/or a wave of tax increases? After 10 years of austerity and a health crisis that has not only highlighted the underfunding in the NHS/social care system, but also high levels of inequality, another phase of deep spending cuts looks unlikely. Indeed, reports indicate that Prime Minister Boris Johnson has ruled out further austerity and a public sector pay freeze, while sticking to his ‘levelling up’ agenda, including increased spending on transport infrastructure in the north. Chancellor Rishi Sunak has made similar noises.
Despite a manifesto pledge not to raise rates of income tax, national insurance or VAT, tax hikes of some description seem more likely. Tax increases on wealthy individuals and corporations might not play well to the Tory party’s traditional voter base, but would serve as a nod to concerns about inequality. Moreover, if done correctly, they might prove less economically damaging than across-the-board tax hikes (wealthy individuals are likely to spend less of their income, and the UK corporate tax burden is currently amongst the lowest in the G20).
There has been speculation for several years now that higher-rate tax relief for pension contributions will be abolished. And a recent survey indicated that both a wealth tax and an “excess profits tax” (levied on industries, such as supermarkets, whose revenues were boosted during the crisis) would be popular with the public.
Nevertheless, steep tax hikes will be politically difficult and would risk derailing the post-covid economic recovery. This will leave the authorities looking for other options to tackle the debt burden.
The recent battle against coronavirus has often been likened to that of World War II, and the post-war experience in reducing the debt to GDP ratio could also prove germane. According to data from the Office of Budget Responsibility (OBR), UK government debt peaked at around 270% of GDP in 1946 and three decades later had fallen to just 49% of GDP. This feat was not achieved by steep tax hikes and deep spending cuts, but rather was the result of strong nominal GDP growth (i.e. real growth plus inflation) and negative real interest rates.
There is little prospect of inflation returning to the 6.5% annual average rate that prevailed during the period 1946 to 1976. However, the broad principle – i.e. keeping debt servicing costs below the nominal growth rate of the economy – is likely to be a key element of reducing the debt burden during the coming years. Indeed, Chancellor Sunak has hinted that raising productivity and growing the economy is the preferred option for tackling the debt burden.
A nod and a wink from the Bank of England
In achieving such an aim, it clearly helps to have a ‘cooperative’ central bank on board. In the UK, the policy response to the coronavirus crisis has seen a high degree of coordination between the fiscal and monetary authorities.
In March, the Bank of England (BoE) cut its policy rate to 0.1% and announced £200bn of quantitative easing (QE, or buying bonds in the secondary market). In April, the government announced that the BoE would directly fund the sharp increase in expenditure by effectively granting an unlimited overdraft facility at the bank (known as the “Ways and Means Facility”), thereby facilitating spending in the short-term without having to issue government bonds, or Gilts.
The intention is that the government’s ‘overdraft’ at the BoE will be temporary and will be paid off eventually. However, ‘temporary’ measures have a tendency to become increasingly ‘permanent’; the £435bn of assets built up from the BoE’s 2009-16 QE programmes still remain on the bank’s balance sheet. Even if the government does issue Gilts to pay off its ‘overdraft’, there is every chance that the BoE will buy them in the secondary market as part of an expanded QE programme. At the May meeting of the BoE’s monetary policy committee, two of the nine policymakers voted to increase QE by an additional £100bn, and there is a strong possibility that a majority will agree to further purchases during the coming months.
Indeed, when quizzed recently about the bank’s bond buying, BoE Governor Andrew Bailey indicated that one of the main purposes of the QE programme was to “spread the cost of this thing to society” and help the government avoid a return to austerity. This said, it is important to note that the BoE is not just doing the government ‘a favour’ by supporting the Gilt market. Rather, with the bank’s forecasters anticipating that the sharp downturn in the economy will result in an undershoot of its 2% inflation target this year and next, policymakers can argue that the stimulus resulting from expansionary fiscal policy combined with QE bond purchases is entirely consistent with its policy framework.
Against this backdrop, monetary policymakers are understandably wary of a renewed bout of fiscal belt-tightening that could stifle growth and increase downside risks to inflation. With both policy rates and government bond yields close to zero, central banks acting on their own have limited firepower to counter economic weakness and below-target inflation. However, by providing monetary financing and keeping debt servicing costs low, they can provide a crucial supportive role to governments adopting fiscal stimulus.
It is important to note that, as it stands, QE does not represent ‘free’ money for the government. The BoE finances its Gilt purchases by creating reserves that are credited to commercial banks’ accounts, and the BoE pays Bank Rate (currently 0.1%) on these reserves. However, as this interest is less than the Gilt coupon payments paid by the government, the process effectively reduces debt servicing costs. In addition, by keeping market interest rates low, the Bank enables the government to issue new debt with low yields.
There is speculation that interest rates could go even lower. Several members of the MPC, including Governor Bailey and Chief Economist Andrew Haldane, have recently refused to rule out a move to a negative interest rate policy (NIRP) akin to that currently adopted by the Bank of Japan and the European Central Bank. The challenges posed to the financial system from negative interest rates have previously been seen as a barrier to NIRP in the UK and the US. However, the pushback against the policy from UK policymakers has been markedly less vociferous than their US counterparts. Indeed, the yield on the 2-year Gilt recently turned slightly negative for the first time ever.
In turn, this could leave the pound looking vulnerable during the coming months. Although Sterling is currently undervalued on some measures, the combination of a large current account deficit (a broad measure of the gap between exports and imports), aggressive monetary stimulus and uncertainties over UK-EU trade relations threatens to put further downward pressure on the currency.
Implications for investors
All of this has implications for investors. Although inflation in the near-term is likely to fall as a result of weak demand and historically low oil prices, the longer-term risks are skewed to somewhat higher inflation as fiscal and monetary policy combine to stimulate the economy and prevent a damaging period of deflation. In this regard, domestic and international equities offer better prospects for long-term real returns than Gilts. Furthermore, given the likelihood of a prolonged period of negative real interest rates, gold could prove a more attractive portfolio diversifier than government bonds going forward. More generally, the threat of higher taxes highlights the importance of tax-efficient financial planning.
20 May 2020
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.