Invesco: General Election 2019: What spending promises might mean for gilts

 

After a decade of fiscal constraint, the increase in investment spending proposed by both the Conservatives and Labour raises the potential for higher gilt yields from two different perspectives.

First, it is not unreasonable to expect some increase in the risk premium from a loosening of the UK’s fiscal framework at a time of economic uncertainty posed by Brexit. Indeed, Moody’s only a few days ago downgraded the UK’s outlook to negative, citing the shift away from the focus on debt reduction.

Second, the combination of additional current and investment spending on the scale proposed (admittedly without knowing tax plans) could well boost economic growth and potentially inflation – particularly at a time when slack in the labour market is diminished.

It is important to qualify my view. With inflation still low and central banks operating very easy monetary policy, I don’t think gilt yields are likely to rise precipitously and certainly not in isolation from other government bond markets.
However, with gilt yields still very low by historic standards and the balance of risks towards somewhat higher yields I think it prudent to maintain a cautious stance towards duration.

From its peak in fiscal year 2009-10 of 10% of GDP, the UK government’s deficit has been in steady decline as a result of cuts to spending and capital investment and a gradual recovery in tax receipts. By the last fiscal year end (March 2019), the deficit had fallen to 1.9%, its lowest since 2001-02.

Against a backdrop of modest GDP growth, however, progress with the debt ratio has been much more muted. Government debt as a percentage of GDP peaked at 86% in 2014-15 but has only fallen to 84% in 2018-2019.

Nonetheless, the reduction in the UK government deficit has resulted in a gradual decline in net gilt supply from a peak of over £200bn in 2009-10 to below £32bn in 2018-19. In combination with low inflation and quantitative easing, this decline in net supply has helped underpin the strong gilt market in recent years.

 

The current Conservative government has pursued fiscal policy in the context of two key fiscal targets. First, to achieve structural borrowing below 2% of national income in fiscal year 2020-21, and second, to ensure a falling debt to GDP ratio from 2020-21. And, as we have seen, the government had by March already achieved the first target.

However, since then, three developments have served to weaken the fiscal outlook. The first but perhaps least important was the conversion of a proportion of the outstanding stock of student loans to government expenditure, to reflect the fact that a significant proportion will not be repaid.  For context, this change would have added £12.4bn per year to spending in the last fiscal year.

Second was the government’s one-year Spending Round announced in September, which pledged the largest increase of day-to-day government department spending in real terms in 15 years – a real terms increase of over 4% (and equivalent to over £20bn in cash terms).

This spending technically keeps the deficit just inside the 2% limit of national income but obviously leaves it vulnerable to any slight downward GDP growth revision.

But third, and perhaps most significant, have been the new fiscal frameworks proposed by the Conservative and Labour parties in the run up to the general election. Interestingly, both parties are proposing to separate investment spending from day to day (or current) spending and are also moving away from a debt ratio target.

The Conservative Party, for example, has proposed a target to eliminate the current deficit (thereby, importantly, excluding investment spending from the rule) in three years. Today, UK current expenditure is actually in a small surplus, so this target would in fact give them room to run a small current deficit for the next two years.

The Conservative Party’s investment spending rule proposes a 3% of GDP limit to net investment.  Today, that figure is equivalent to 2.2% of GDP; thus, at 3% a conservative government could increase capital spending by in excess of £20bn p.a. This would take government investment spending as a proportion of GDP back to levels last seen in the late 1970s.

Equally important, in place of the debt/GDP target, there would be a limit on the percentage of tax revenues accounted for by debt interest costs – in this case 6%. Today, that figure is close to 2% of GDP, so this represents a potentially significant change on the current framework.

The Labour Party’s plans also entail looser policy towards current spending with a target to balance the current budget only over a rolling five-year period. However, it is in Labour’s investment spending plans that the starkest differences between the two parties becomes apparent.

With a limit of 4% of GDP, investment spending in the UK could increase by a very large amount (£55bn p.a. in cash terms), representing the largest proportion of investment spending of GDP since the mid-1970s.

What we don’t yet know of course are the tax plans of either party. However, spending commitments on this scale are likely to lead to a sharp rise in gilt issuance, albeit from a low base.

 

Investment risks
The value of investments and any income will fluctuate and investors may not get back the full amount invested.

 

Important information
All data is as at 15.11.2019 and sourced from Invesco unless otherwise stated.

Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.

This document is marketing material and is not intended as a recommendation to invest in any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication. The information provided is for illustrative purposes only, it should not be relied upon as recommendations to buy or sell securities.