Rabbits, redistribution and rate risks: AJ Bell’s Laith Khalaf assesses how the markets have reacted to the Autumn Statement

by | Nov 17, 2022

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Laith Khalaf, financial analyst AJ Bell
  • Pound under pressure, but markets tranquil over Autumn Statement
  • A few unexpected rabbits crept out of the hat
  • Back-ending tax rises and spending cuts is a smart move
  • The Treasury could be in for a windfall next year if the Bank of England is on the money
  • The public finances are at the mercy of inflation and interest rates, and QE is going to cost £133 billion

Laith Khalaf, head of investment analysis at AJ Bell, comments:

“Just six weeks after the doomed mini-budget, the Tiggers have relinquished control of the public purse, and the Eeyores are now back in charge. Markets are suspicious of rampant optimism when it comes to government finances, especially in such volatile political and economic conditions, so the new Chancellor’s steady, calculated approach will help keep global investors on side.

“The Chancellor’s tax rises and spending cuts are designed to fill a black hole in public finances which has been left by a weakened economic outlook, higher government borrowing costs, and the enormous energy support package provided to consumers and businesses. Of these three, it is only the energy support scheme that is under direct government control, and that intervention commands widespread public and political support. The Autumn Statement represents in part a transfer of financial resources from the public sector and taxpayers to energy consumers, and clearly there is therefore a lot of overlap between the beneficiaries of fiscal policy and those picking up the bill.

“One might ask what is the point of robbing Peter and Paul to pay Peter and Paul, but there is actually a lot of redistribution going on along the way, including from wealthier to poorer households. The government is also lessening pain now for everyone through the energy price freeze and spreading it out in the longer term through tax rises and spending cuts. The Exchequer is effectively acting as a financial buffer between global energy markets and UK consumers by absorbing a lot of the price shock up front, but then recouping the cost of that over time.”

Pound under pressure but markets tranquil

“The reassuring impact of the publication of the OBR report should not be underestimated either. Capital markets are being asked to fund the government’s deficit spending and inviting them to do so without inspecting the books was always a recipe for disaster. Gilt markets have barely fluttered an eyelid in response to the Autumn Statement and while the pound has come under pressure, this is really just trimming back some of the gains seen in the last week or so and as yet the price movement is small compared to the sharp fall in sterling witnessed in the wake of the mini-budget. It’s also notable that the power companies SSE and Centrica saw a jump in their share prices, suggesting that investors think the extension of the windfall tax isn’t as bad as expected. In the first instance Jeremy Hunt will therefore likely be satisfied he hasn’t broken the unwritten but important fiscal rule ‘don’t spook the markets’.”

Unexpected rabbits

“There were a surprising number of rabbits pulled out of the hat given such a dour economic outlook, such as increased spending for schools and the NHS, and business rates relief. Many will also be breathing a sigh of relief that benefits and state pensions will be uprated with inflation, though whether that counts as a rabbit from a hat or a fulfilled obligation depends on your expectations leading up to this statement.”

Back-ending tax rises and spending cuts is a smart move

“The decision to back-end some of the spending cuts and tax rises needed to balance the books looks like a sensible one given the highly volatile nature of the economic picture and the need to keep the wheels of the economy turning in the here and now. While the publication of the OBR report is vital to instil confidence it’s not gospel, especially when energy prices and interest rate expectations are bouncing around like a Slinky on a trampoline. Pushing back taxpayer and public sector pain gives the government an outshot of a positive economic surprise materialising as we move through next year, which could allow them to ease off some of the longer dated measures announced today. If the economic clouds do miraculously clear, that could therefore provide some room for fiscal largesse as we approach the next election.”

The Treasury could get a projection windfall next year

“This isn’t quite the Hail Mary it might at first seem, because the OBR’s economic projections are based on market expectations that the Bank of England will raise rates to 5% next year, which the central bank itself has said is over-egging the pudding. With so many volatile variables in the mix no-one knows precisely where interest rates will peak, but if the Bank is right that could lead to a bit of a fiscal windfall for the Chancellor next year, as it would mean the OBR paring back its projection for the costs of government debt and pushing up its growth forecast. In any case, current electoral polls suggest there’s little for the government to lose in getting a lot of the bad news out of the way now when everyone is braced for it and hoping to be able to deliver some better tidings further down the line. Jeremy Hunt may be playing bad cop today, but he might have an eye on auditioning for the role of good cop in the not too distant future.”

The public finances are at the mercy of interest rates and inflation

“It’s also notable that the new fiscal rules announced by the Chancellor are less onerous than the old ones, increasing the time period the government has to balance the books from three to five years. On the existing three year time frame, the government is falling short of its previously announced targets, so moving the goalposts was clearly deemed necessary to give the Chancellor a better chance of getting the ball in the back of the net. But one of the big headwinds the Treasury still faces and a large factor in the current black hole is the elevated cost of government borrowing. Gilt yields have risen, which is more of a slow burn on government finances because it only affects new borrowing which is a fraction of the total amount of debt the government pays interest on.

“More immediate pressures are coming in the form of inflation pushing up the cost of around £500 billion of index-linked gilts, and rising base rate increasing the interest paid on over £800 billion of gilts held in the Bank of England’s QE scheme. Very small adjustments on such enormous sums can generate extremely big numbers and recent movements in interest rates and inflation have hardly been modest. Indeed the OBR now expects the government to have to fork out £133 billion over the next five years to cover the cost of interest and capital losses on the QE scheme, increasing debt by 2.1% of GDP over the next five years.

“Debt interest payments are now a big swing factor in the public finances because of the large debt pile, the exposure to inflation through index-linked gilts, and the heightened sensitivity to interest rates produced by the QE scheme. Very small movements in rates and yields, either positive or negative, can produce a starkly different pitch for the government’s tax and spending plans and by extension, the battleground for the next election. With such an uncertain economic picture, inflation and interest rate expectations could easily move in either direction. The new Chancellor will be desperately hoping the coin toss lands in his favour.”

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