Job done for Reeves but numbers far from certain

The wait is over. UK Chancellor Rachel Reeves delivered her much anticipated November Budget on Wednesday, ending weeks of rumours and leaks that had created a general feeling that all measures were on the table – now investors, businesses and taxpayers alike can fill in the empty cells on their spreadsheets and calculate what’s left.

Gilts were extremely volatile on the day, not least because the Office for Budget Responsibility (OBR) erroneously published an outline of Reeves’ plans before she stood up to speak in the House of Commons. In the end, they did not have a bad day at all as long end yields fell, helping the curve to bull flatten by a decent margin.

Tacit approval from the Gilt market was perhaps job one for Reeves, but for investors there are a few key points worth highlighting.

First, the most important feature of yesterday’s Budget in our opinion is that the fiscal consolidation is heavily backloaded, with tax raising measures taking effect further down the line. Net borrowing is in fact expected to be higher in the near term than previously expected. Compared to the OBR’s March forecasts, the 2024/25 fiscal year just passed now includes an additional £12bn in net borrowing. Net borrowing is expected to be £21bn, £15bn, £18bn, and £9.5bn higher than March’s projections in the four years to 2028/29, before switching to £6bn lower than the March projections for 2029/30. The main reason for the abrupt reversal of fortunes in the later years of the forecast horizon are tax hikes that start kicking in in 2027/28 but accelerate in 2028/29 and 2029/30. Spending, on the other hand, is set to be consistently higher by around £20bn every year. That said, as a percentage of GDP, the forecast is in fact for net borrowing to decline from 5.1% in the last fiscal year to 4.5% in the current one, and to continue declining after that to reach 1.9% of GDP in 2029/30.

The maths here is not ideal for bondholders. There is certainty that spending is higher than previously forecasted as this is happening in short order, but there is uncertainty about the level of future tax collections that will only occur a few years from now. As mentioned here, raising income tax would have been better from a government cashflow point of view, since it is harder to avoid and collected promptly. Raising several unrelated taxes makes forecasts more difficult, and backloading the measures gives plenty of time for badly wounded taxpayers to change their behaviour and try to avoid paying the higher rates once they become operational. While the OBR does account for “behaviour adjustments”, it is almost impossible to forecast how millions of people and businesses will adapt to tax increases. This is an obvious statement, but from a bond market perspective the problem is that balancing the UK government’s books depends heavily on these assumptions coming to pass, as opposed to the greater revenue certainty of an income tax hike.

Second, taking the OBR numbers at face value, we do believe that this time around the fiscal “headroom” of £22bn is more reasonable. The small headroom in Reeves’ October 2024 Budget has been one of the key reasons why the economy has been sluggish. Very quickly after the event, businesses and homeowners concluded Reeves would have to come back for more tax hikes or spending cuts at some stage, likely putting decisions on investment, hiring and house purchases on hold until clarity emerged. While £22bn is not a particularly high margin for error compared to previous Budgets, it does give a lot more room for manoeuvre than the meagre headroom of around £10bn that was left last year. Despite the lingering uncertainty on future tax revenue, we do believe more of these economic decisions will get the green light now there is more clarity.

Lastly, the OBR did revise some of its parameters to reflect weaker productivity and potential growth, but the new numbers still might end up being on the optimistic side. Growth is estimated to average 1.5% over the next five years, which while plausible we would consider to be a best-case scenario. In addition, there are a few interesting adjustments that the OBR believes will lead to a higher tax intake. There is a slightly higher inflation projection in the near term, which adds to nominal GDP and nominal tax revenues. There are also adjustments caused by the fact that minimum wages are increasing and some corporate taxes such as business rates have increased. The OBR expects these to translate into lower corporate investments and higher consumption, which increases tax revenues. These might not sound very material, but the inflation change adds £14bn in tax receipts in the five-year period to 2029/30, while the change in the balance of investment and consumption adds £5bn. Again, we take these with a pinch of salt.

We were left a bit puzzled by the positive reaction in Gilts, and we would attribute the rally to the fact that there were no unexpected bombs dropped in the Budget. At the same time, we don’t see an imminent risk of a sharp sell-off. However, we do believe Reeves’ numbers are subject to a long list of variables moving in the right direction, and as we’ve said there is considerable uncertainty on some of these. We would not be surprised at all if in the next few quarters one or more of these variables deviates from the OBR’s forecast and markets quickly start pricing in further measures as a result. For the time being, we continue to think there are better risk-off trades out there than Gilts. We also believe UK corporate credit quality remains strong, and beyond potentially some high yield issuers in the gaming sector, we don’t expect to see near term weakness in UK corporate bond spreads.