With the Budget approaching, bond markets are watching closely for signs of fiscal discipline. Connor Godsell, Investment Manager in the Liontrust Fixed Income team, assesses the risks and opportunities facing gilts, and considers what a market-friendly Budget might look like.
The UK Budget being delivered around this time of year, combined with the uncertain nature of the Chancellor’s proposals, naturally lends itself to Halloween-related imagery.
The bogeyman of higher inflation, fiscal chainsaws, slashing spending…you get the picture.
This year, however, you get the distinct impression that most people, whether in markets or politics, are keen to turn out the lights and pretend to the trick-or-treaters that no one is home.
Should John Healey get through next week without incident, that will likely be considered a success by all sides. The spectre of the ‘mini-budget’ of 2022 remains, and no one wants a sequel to that particular horror show.
Dialling up the suspense
It’s been quite the year for the UK bond market – geopolitics, a change in government, rising yields – there’s been a lot to contend with. You’d be forgiven for thinking that the run-up to this Budget has been especially fraught with chaos and trepidation, although recent years would suggest this level of disruption has become normalised. ‘Twas ever thus, as they say.
The rise in yields has seen the Chancellor’s headroom eroded, energy inflation is likely to see the Bank of England’s Monetary Policy Committee increase rates, and globally fixed income markets have taken a dim view of fiscal laxity – see the blow-out in the spread between French and German government bond yields for the latest evidence (or perhaps more accurately, the latest warning) on that front.
Altogether, this has constrained much of the wiggle room that a left-leaning Labour government might have sought to exploit given its relative popularity.
The reality is that breathing space has been restricted, and if Healey wants to avoid being buried alive by his own policies, the job will require something more akin to fiscal pruning than any axe-wielding on either side of the ledger.
There are some chinks of light though – GDP growth has been better than expected, while productivity upgrades and revisions to labour assumptions should improve the growth forecast from the Office for Budget Responsibility (OBR), and therefore the tax take.
This has likely dampened the pain of higher yields somewhat, but has not reduced the ominous threat of what less careful policy changes could do to gilt yields.
The Treats
From a bond market perspective, the Chancellor’s rhetoric since taking the job has been somewhat reassuring – a steadfast commitment to the fiscal rules, à la Rachel Reeves, alongside mentions of reducing the welfare bill and limited tax increases.
This is the fine balance that the government needs to tread, simultaneously addressing market concerns on the deficit and avoiding measures which could adversely impact growth, all the while trying not to upset its own backbenchers by appearing too fiscally indentured to bond markets. In hock, as some might call it.
And in some ways, simply continuing to pay heed to these concerns could provide a constructive backdrop for bonds. But we’re not greedy – we don’t expect any haul of bond market goodies to digest.
Some modest tax increases (such as those on banks mentioned recently) and some efficiency savings will be sufficiently palatable.
Larger changes in this Budget are more likely to involve how spending is managed, given the government’s devolution agenda.
This should be of less concern to markets even if it will take up a good proportion of the airtime.
The Tricks
What would get markets worried then? First of all, we think that headroom being lower than ~£15bn would be taken poorly. As would any surprising policy announcements which rely on unrealistic assumptions to balance the books.
Markets will likely give Healey some leeway, not necessarily expecting headroom to be built back to the ~£24bn estimated by the OBR in March.
An aggressive push on defence spending beyond what has already been announced seems unlikely but would probably be viewed dimly given the low multiplier effects on growth of any additional outlay here.
In our view, there is also a risk that they go further on cost-of-living policies and extend measures around energy bills next year. How policies like this would be funded would be closely scrutinised, alongside any impact on the inflation profile too.
The Twist
Some of the bigger picture policies that the Prime Minister has announced have been met with a general, if somewhat muted, sense of pragmatic agreement.
The future removal of the triple-lock to fund social care improvements sounds like a reasonable trade-off and partly addresses a policy choice which has had far more impact on public finances than was expected when it was implemented.
Improving the relationship with the EU seems sensible in both an economic and geopolitical context, while the recently announced policies around oil and gas in the North Sea have a defensible economic rationale, if not particularly consistent with stated climate ambitions.
In our view, however, there remains a risk that the PM will use that net popularity, alongside these broad policy objectives, to seek an early election in 2027.
A quick look at the competition might lend support to this approach – the Tories are improving but still scarred by recent reputation, Reform have faced a number of setbacks of late and the Greens have their own (self-inflicted) problems.
We wouldn’t call it a base case, but it is something to be mindful of, and not necessarily something that gilt markets would take well.
Where to next for markets?
We’d describe the expectation of a fairly benign outcome as broadly consensus, and as such there would likely be a larger reaction in a negative direction for gilts to any fiscal irresponsibility, than a potential rally in the event of a “not much to see here” performance.
There is still the underlying boost to credibility though – the more the UK looks sensible in its fiscal policy choices, the better it looks to international investors.
While it’s unlikely to be the primary factor driving markets in the medium term, removing the event risk would still be an incremental positive in our view.
We remain of the view that the Bank of England will be unlikely to deliver the number of interest rate hikes priced, which should support bonds and see yields move lower as markets move in this direction.
In the short-term, all eyes turn to Healey’s speech next Wednesday. Hopefully this time round, we’ll be less likely to be watching through our fingers.
Then we’ll have meetings from the US Federal Reserve (Wed), European Central Bank (Thu), and Bank of Japan (Fri) to look forward to. No rest for the wicked.
Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The writer’s views are their own at the date of publishing and do not constitute financial advice.
This information should not be relied upon by retail clients or investment professionals. Reference to any particular investment does not constitute a recommendation to buy or sell the investment.
Main image: pumpkins, halloween, scary, david-menidrey-MYRG0ptGh50-unsplash
