JP’s Journal: A poisoned chalice?

For those of a nervous disposition it is best to avoid the Institute for Fiscal Studies (IFS) paper “Constraints and trade-offs for the next government”.

The title sounds benign but it makes sombre reading. In 25 pages it neatly outlines the problems facing the next government. Actually, that is the wrong way to express it. The paper sums up the dilemma that we face as a nation. And to be fair, these are not uniquely British. Much of the euro area faces the same problems whilst runaway spending by the US government poses its own challenges.

It becomes clearer over time that the Global Financial Crisis (GFC) was a watershed moment. The IFS paper shows the sharp fall below the long-term trend line for UK real household disposable income since 2008. In 2024 prices, real disposable income is forecast by the Office for Budget Responsibility (OBR) to be around £28,000 by 2029. The post-war trend up to 2008 indicated that the 2029 figure would be nearer £40,000. Weak real economic growth has tangible consequences.

The GFC, Covid and the cost-of-living crisis define the last 15 years. From a debt viewpoint, the combination of low growth and fiscal support means that national debt is now around 100% of UK GDP. We have been here before, but in the early 1960s global economies were entering a period of strong growth (with a few interruptions); this is not the case now unless you believe in an AI miracle. Debt service costs matter but in a zero-interest rate regime the focus tended to be neglected – hence the ‘Magic Money Tree’ approach espoused in Modern Monetary Theory. But when interest rates change things can look very different. Again, the IFS is helpful in highlighting the key issue. Plotting nominal growth against current government debt interest costs (as a % of GDP) shows a relationship that has not been worse (1951 -present). The bottom line is that any tax cuts in the next budget will be reversed pretty soon after.

A brief summary of the challenges may be helpful. Western societies have aging populations that will put a strain on health and social provision and electorates expect State support in an increasing range of activities. Defence cuts, which were significant in economic growth phases, will need to be reversed. For all his support of Ukraine Prime Minister Johnson did not spell out the implications. At the same time the transition to net zero will require massive capital investment and the replacement of an important revenue source (Fuel Duty). New commitments around childcare will further eat into budgets whilst the rise in long-term illness, particularly in younger demographics, is pushing up benefit costs.

Where to look for savings? It is difficult to see meaningful cuts in the unprotected areas such as courts, prisons, and local government. Government capital spending may take a further hit, but we already have a low investment rate relative to our G7 peers. A good question to ask is why a mile of railway cost 6-8 times that of an equivalent in France or Germany. Is it just down to our size? I doubt it. The danger is a vicious circle of low growth, rising debt service costs and unfulfilled expectations. It sounds like the next government is picking up a poisoned chalice. 

Yields on 10-year US treasuries ended 3bps higher on the week, a move matched by UK gilts, whilst German rates were broadly unchanged. As expected, the European Central Bank kept rates on hold and guidance was unchanged. However, the tone sounded more dovish, supporting the comments made by President Lagarde to Bloomberg that there was likely to be majority support for a rate cut by the summer. The emphasis remains on ‘data dependency’ but with euro area economies struggling, there is a realistic prospect that conditions may be right for an earlier cut.

Credit markets saw spreads fall over the week. It was nothing major but confirmed the reversal of post-Christmas weakness. Valuations are at the narrower end of my expected range, with extra supply expected to weigh on spreads – so, some short-term caution is justified. Last week also saw statistics on the insistence of profit warnings from UK listed companies. According to EY-Parthenon the percentage of companies issuing a profits warning in 2023 climbed above the high seen in 2008. Cited causes included rising borrowing costs, higher wages, energy and transport costs, and weaker consumer spending. In truths, the data surprised me, especially the high number of profit warnings from software and computer service providers. 2008 felt a lot worse.

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