Not a budget for growth, but case for UK financials remains

With the first Labour budget since 2010 dominating headlines, hallway conversations and family gatherings in the UK for the past couple of months, the stakes were very high indeed for the chancellor, Rachel Reeves, on Wednesday. Political opinions aside, the budget is usually an important event for market participants and this one was no exception.

First, even if there was uncertainty regarding the numbers and percentage changes on tax and spending, most of the bolder measures were already in the public domain. Therefore, from a macro point of view there weren’t many complete surprises for markets. There are many things that markets dislike, but the worst of all is uncertainty; now that investors and companies know what the changes and new rules are, they will feel better able to plan ahead and make more informed decisions.

Second, this is not as billed a “budget for growth” in our view. While some of the investment initiatives might turn out to be positive and end up raising the UK’s potential growth rate, execution is key. Sadly, the track record of government-led investment sprees around the world is not particularly encouraging. What we think will have a clearer and quicker impact is the increases to the minimum wage and national insurance contribution by employers. With hiring becoming more expensive at a time when there are still some shortages in the labour market, the impact of these measures is likely to be inflationary. Gilts reacted accordingly, with 10-year yields rising around 15bp and the market pricing in a shallower path expected for rate cuts going forward. The impact on growth is uncertain, as those on the minimum wage have more money at the margin but businesses are less incentivised to hire. In addition, the increases to capital gains and carried interest taxes, combined with the end of the “non-dom” tax exemptions, make it less attractive to put capital at risk as the expected return is lower while the risks involved are unchanged. The impact of this in the medium term is not positive for the UK’s potential rate of growth, though this is unlikely to show up in next year’s numbers.

Third, even if the aforementioned tax increases are not positive for growth, analysts’ projections are not likely to be revised downwards dramatically. The Bloomberg consensus for UK growth in 2024, 2025 and 2026 is 1.0%, 1.3% and 1.5% respectively. The Office for Budget Responsibility (OBR, the UK’s independent government spending watchdog) expects UK growth to be just over 1% in 2024, 2% in 2025 and 1.5% in 2026, which looks rather optimistic against the IMF’s corresponding projection of 1.7%, 1.68% and 1.65% for the G7 nations. Uncertainty around these projections is high, but the UK economy has bounced back markedly from the technical recession experienced in the latter half of 2023 and we do not think Reeves’ budget derails it. Looking at credit spreads, we think the impact is likely to be neutral to slightly negative in certain sectors, with higher beta spreads having a larger reaction, but we don’t think spreads look significantly any cheaper or more expensive than they did on Wednesday morning.

Finally, given the scars left by the UK’s Liz Truss “mini budget” experience, we think investors (particularly international ones) were somewhat nervous about what the new chancellor would or would not do. This may not be a budget for growth, but it does not contain huge amounts of unfounded spending and should not therefore lead to negative rating actions or stress in the financial system. Issuance in the Gilt market will be markedly higher, however, which is partly the reason why Gilt yields moved higher on Wednesday and have continued to do so on Thursday morning.

The main impact in financial assets and investors’ expectations in the short term is likely to be a flatter path for interest rate cuts going forward. We have thought for a while that, in the context of a global fixed income portfolio, there are better risk-off assets than Gilts. This has not changed. It has also been part of our investment thesis that UK spreads, particularly those of banks and insurance companies, look attractive. These issuers are strictly regulated and benefit from geographical diversification, and the fact that London is one of the most important financial centres in the world. This has not changed either.