The UK Gets All ‘Austere.’ Again.

Editors’ Note: Our political commentary is non-partisan by design. We favor no political party nor any politician and assess political developments for their potential economic and market impact only.

UK Chancellor of the Exchequer Rishi Sunak unveiled the 2021 Budget on Wednesday, outlining projected fiscal policy for the next five years. And with that, the UK became the first major nation to attempt to address the question, how will they pay for that massive mountain of COVID relief spending? The answer, at first blush, is “austerity.” That is how a lot of headlines and politicians summed up the package of tax hikes and apparent spending cuts. In our view, though, there is a bit more here than meets the eye. To us, this is a budget that, aside from a near-term stealth income tax hike, leaves a lot of wiggle room before the big moves kick in … and really only takes the borderline obvious move of curtailing emergency pandemic spending. Heck, considering most of the tax provisions discussed today don’t take effect until the year before the next election—presuming Parliament even approves them—we wouldn’t be at all surprised if this turned out to be a lot of near-term sound and fury with little eventual substance. Not that any of this is make or break for UK stocks, but we can see plenty of room for a better-than-expected outcome to lift sentiment.

The figure getting the most ink in Wednesday’s coverage was £470 billion. That is how much money the Treasury is projected to have spent on COVID assistance once all is said and done. Echoing sentiment following Britain’s fiscal response to 2008’s global financial crisis, UK headlines and politicians alike were focused on solving the how to pay for it problem as soon as possible—a notable change from the US and much of Continental Europe, which seem content on kicking the can for a while longer. Looking at the Treasury’s Budget report, we think Her Majesty’s Treasury probably has plenty of latitude to do the same if politicians preferred that path. For it isn’t the total amount of debt outstanding that really matters to public finances, but how much the Treasury has to spend servicing it.

Even after the COVID-related borrowing binge, UK bond interest payments are plunging—and projected to stay low. In fiscal 2019 – 2020 (which ran from 4/1/2019 – 3/31/2020), the UK paid £36.6 billion in central government bond interest.^[i] In 2020 – 2021, when government forecasters expect new government borrowing to near £400 billion, debt interest payments are projected to fall to £23.9 billion. From there they inch a bit higher, but even five years from now, the Office for Budget Responsibility (OBR) projects interest costs remaining below fiscal 2019 – 2020. Now, part of this is because the Bank of England restarted quantitative easing (QE) bond purchases, and it returns all interest to the Treasury. But interest rates fell to historic lows last spring and summer, helping the Treasury issue new debt for next to nothing. Even now, after a recent rise, 10-year UK gilt yields are just 0.78%, enabling the Treasury to refinance maturing debt at a steep discount.^[ii]

As long as debt remains affordable, countries don’t need to pay it off. We have seen a lot of comparisons between COVID-related borrowing and the mountain of bond issuance to pay for WWII, but here is a little secret about that: The US never technically repaid wartime borrowing. It is still on the books. Uncle Sam just paid interest and refinanced maturing bonds as they came due. Meanwhile, the economy grew hand over fist, reducing debt-to-GDP even as the absolute level of debt never fell. The UK had a similar experience with bonds issued to fund the 19^th century’s Irish famine relief and deal with the fallout of the South Sea Bubble’s implosion. Time and again, history has shown a growing economy is all governments need to keep debt manageable, even when it spikes temporarily.

We say this not to quibble with the government’s choices, but to show why it isn’t at all guaranteed that most of the tax increases announced Wednesday ever take effect. The measure stirring the most angst was the decision to freeze the income thresholds for the UK’s tiered tax rate bands after next year, cancelling the previously planned increase. The thresholds typically rise more or less with inflation so that the taxman doesn’t penalize folks for cost-of-living-driven wage increases. But after raising the threshold on April 1, 2021 for the ensuing fiscal year, the Treasury plans to hold them steady through 2026. Therefore, even though tax rates won’t increase, more people will likely end up with more income exposed to higher rates, leaving them with a larger tax bill.

That is not fun at all. But it is possible that a year from now, with the economy recovering nicely and interest payments plenty affordable, the government changes its mind. It is also entirely possible that enough Conservative Members of Parliament oppose this provision that it gets amended out of the final legislation. It wouldn’t be the first time the government has U-turned on a Budget measure in recent years amid political and popular opposition. Politicians want to be re-elected above all else. You can apply similar logic to the planned freezes in investment tax allowances and pension savings limits.

In a similar vein, Sunak announced plans to jack the top corporate tax rate from a super-competitive 19% to 25%, which would tie for the OECD nations’ sixth-highest. But that increase is scheduled for 2023. The UK’s next general election is scheduled a year later, in May 2024, and Labour Party leader Keir Starmer has stated he isn’t too keen on business tax hikes—a striking role reversal that proves, once again, investors’ biases about political parties often don’t match reality. If the planned increase passes now and polls tighten over the next couple of years, scrapping it at the last minute to steal one of the opposition’s talking points would be crafty politics, to say the least.

On the spending side, we don’t see any hint of austerity. Total public spending and investment are slated to fall this year and next, but that is due nearly entirely to fading COVID relief and the National Health Service’s spending on the pandemic. If spending follows the OBR’s projections, it would “bottom” in fiscal 2022 – 2023 at a level far exceeding fiscal 2019 – 2020’s outlays. Once you strip out COVID-related policies, public investment is slated to increase every year as the government pursues its much-ballyhooed industrial policy. This isn’t austerity any more than the slower growth in spending was austerity in the 2010s. Seems to us like political role reversal, part deux.

For markets, much of this is noise. There isn’t a strong link between fiscal policy and stock returns. Taxes and public spending are only two economic variables impacting a vast private sector. Tax hikes aren’t automatically bad (or good) for stocks, and tax cuts aren’t automatically good (or bad). But big announcements like Wednesday’s help set expectations and can affect sentiment. The Budget’s tax provisions were much milder than the rumors circulating in recent weeks suggested. The widely rumored scrapping of preferential capital gains tax rates didn’t happen, easing one of UK investors’ bigger 2021 fears. If tax increases get watered down further over the next few years, that could provide incremental positive surprise.

Either way though, we don’t see any of this as make or break for UK returns. The growth/value divide has been the primary driver of relative returns in recent years (with a side of Brexit overhang), and the UK tilts heavily toward value. So as long as growth leads, which we expect it to for the foreseeable future, then the UK probably trails global markets even if tax policy surprises positively.