This week’s blog is written by portfolio manager CJ Cowan
In the last few days, we have seen further government climbdowns over their planned spending cuts. In his latest portfolio manager blog, CJ Cowan looks at what this means for Rachel Reeves’s ‘fiscal rule’, how markets have reacted, and what this could mean for investors going forward.
Since becoming Chancellor, Rachel Reeves has announced several belt-tightening measures, including lowering disability benefits and means-testing pensioners’ winter fuel allowance . Following these changes, the headroom she left herself to comply with her ‘fiscal rule’ - to balance day-to-day spending with taxes - was very tight at only £9.9bn this year. Meanwhile these cost-saving measures still needed to be voted through Parliament to be made into law.
After public backlash, the government partly rowed back on the winter fuel allowance cut earlier in June, which evaporated £0.8bn of the original £1.5bn saving. More recently, when over a hundred MPs said they would not support cutting back on Universal Credit and disability benefit spending, the government agreed to water its bill down so much that the entire £4.8bn projected saving will now be lost.
This eats up more than half of the Chancellor’s fiscal headroom. Meanwhile, the OBR has acknowledged its productivity forecasts tend to be too optimistic, and its borrowing projections tend to be too low. Productivity estimates could easily be revised lower, which would make tax rises in the autumn feel like a near inevitability if Labour want to stick to their own fiscal rule.
Gilt yields were drifting higher on Wednesday following Tuesday evening’s vote, but this followed a move lower since the weekend. Overall, the market reaction was quite muted. Investors could tell themselves that these cost-cutting measures were sound ideas that had been badly managed through Parliament, but the overarching principles of the ‘fiscal rules’ would remain intact.
However, a visibly tearful Rachel Reeves at Prime Minister’s Questions, combined with Keir Starmer not answering a question as to whether she would remain in her job, fuelled speculation that it was all over for her as Chancellor. A replacement would likely be more left-leaning, free-spending, and less inclined to balance the books. This was why gilt yields spiked higher, and sterling weakened as investors questioned the ongoing creditworthiness of the UK government.
In last week’s blog, Ian discussed NATO members’ agreement to spend 5% of GDP per year on defence, split out as 3.5% on ‘core defence’ and 1.5% on ‘resilience and security’. Even though the latter will likely comprise of infrastructure investment that was going to happen anyway, it still means a big spending increase. So why was sterling higher and gilt yields well-behaved, but this week the opposite happened?
One reason is the defence commitment only comes into effect in 2035, so funding it is tomorrow’s problem. Perhaps there is also some disbelief among gilt investors as to whether it will really happen given few NATO members stuck to prior spending pledges.
However, another reason is that defence spending will create jobs, lead to an expansion of industrial supply, and ultimately deliver economic growth. Conversely, welfare spending, while vitally important, only stimulates demand and is more likely to be inflationary.
Shortly after PMQs, Keir Starmer backed Rachel Reeves to stay in her job and by Thursday afternoon gilt yields had retraced some, but not all, of Wednesday’s moves.
The rebellion in Parliament has shown that many Labour MPs are unwilling to take measures to rein in burgeoning government spending. This comes as recent YouGov polling suggested that if a general election were called, Labour would win only 178 seats compared to the 411 it won in July last year. Meanwhile, Reform UK would be the largest party with 271 seats, although they would be short of a majority.
Given this political backdrop, it is unsurprising that MPs want to placate their constituents, but the UK, much like the US, remains on an unsustainable path of debt-driven spending. If tax hikes come through in the autumn, we would expect them to further stifle growth. This would leave room for the Bank of England to reduce interest rates further, which should be good for gilts. However, with market-implied inflation rates at lows not seen since 2021, we are inclined to think inflation-linked gilts are looking more attractive.
CJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPHil in Economic and Social History from Brasenose College, University of Oxford.
Who will pay for our defence commitment?
This week, NATO member states committed to spend an amount equal to 5% of their respective GDPs on defence each year by 2035. In his latest portfolio manager blog, Ian Jensen-Humphreys questions if this a realistic commitment that the UK government can make, or is it just empty posturing?
