Conclusion: Fiscal consolidation, issued in detail by the Spending Review yesterday, will benefit the UK’s long-term economy, however over the intermediate term austerity should squeeze the consumer and dampen growth prospects. We do not have an investment position in the UK; and we’re standing clear of an investment position in the UK as rising inflation encourages stagflation.
It’s been an important week of economic releases in the UK. Below we highlight the UK Spending Review, Bank Levy, and developing macroeconomic outlook.
Yesterday’s release of the Spending Review by Chancellor George Osborne detailed the 4 year plan to slash the country’s £156 billion deficit to 2% of GDP; although the country’s austerity measures have largely been priced into the market, the Spending Review reinforces the country’s commitment to fiscal consolidation, captured by Chancellor Osborne statement that the country needs to “stay the course” of spending cuts. While we applaud the discipline to cut wasteful spending, the UK economy is by no means out of the woods (more below under Economic Outlook).
Here are a few highlights from the Spending Review:
- £81 billion cut from public spending over the next 4 years.
- 490,000 public sector job cuts over the next 4 years.
- Pledge to maintain spending on National Healthcare Service (universal healthcare) and Foreign aid.
- 7% cut in funds for local governments by 2015.
- Estimated 20% cut in most government departments.
- All UK companies are set to benefit from a gradual cut in corporation tax over the next four years, from 28% now to 24% in 2014.
- Debt interest payments will be lower by £1 billion in 2012, £1.8 billion in 2013, and £3 billion in 2014.
- The state pension age for men and women will reach 66 by the year 2020, from 60, saving over £5 billion a year by the end of the next Parliament.
- Child Benefit to be removed from families with a higher-rate taxpayer. The Office for Budget Responsibility has upgraded estimates of savings from the measure to £2.5 billion a year, from around £1 billion. Child Benefit will now continue to be paid until a child leaves full-time education at the age of 18 or even 19.
- £30 billion to be invested in transport projects over the next four years, including £14 billion to fund maintenance and investment in railways (*more than was invested during the past four years).
Today, the government drafted legislation on a permanent Bank Levy that is expected to generate revenue of ~ £2.5 billion annually. The levy would apply to UK banks, building societies, and UK operations of foreign banks with more than £20 billion in liabilities. While Germany and France also said over the summer that they’d consider similar charges on banks, currently the UK’s unilateral levy puts competitive risk on its financial sector.
The levy is a win from a populace perspective, due to the strong outcry on banker compensation and as Mark Hoban, Financial Secretary of the Treasury, puts it, the levy ensures that “banks make a fair contribution in respect to the potential risk they pose to the British financial system and wider economy.”
The exact details of the levy on individual banks have yet to be finalized; however analysts expect it to hit hardest at Barclays, RBS, HSBC, Standard Chartered, and Lloyds.
As we noted in our post on 10/8 titled “UK and Inflation’s Ugly Head”, PM David Cameron and his government are now at a crossroads as austerity measures in the UK squeeze the consumer via higher VAT, lower wage, and fewer job opportunities, while inflation continues to rear its head among slower growth prospects into year-end and in 2011. Cameron and Co. may well have to do more than fiscal consolidation to encourage growth over the intermediate term. Here’s the set-up we see:
- Go the likely route of the US (and potentially the Eurozone) in issuing some form of QE2, ie printing money which should further inflate prices and potentially depreciate the Pound, and/or
- Raise the benchmark interest rate to quell inflation, but risk further choking off growth
In either case we see downside growth prospects over the next 18 months.
The release of the BoE Minutes from the October 6th and 7th meeting on Tuesday show that the Committee opposed raising the interest rate 25bps from the current level of 0.5% by a majority of 8 to 1. Andrew Sentence continues to believe that the Bank must head off inflation, which is already above the target at 3.1%, by raising the interest rate, a position we agree with. The minutes suggest there was little support for QE, except for Adam Posen who sees a need to head off deflation. The Committee agreed that bank credit availability remains tight and that while business are cash heavy, they are choosing not to deploy it. They see further downside risk to the broader economy due to fiscal consolidation, as weaker income growth and spending roll over alongside confidence.
Given the outlook for stagflation, we’re going to wait and watch to see how Cameron’s government steers the economy over the intermediate term. We successfully traded the GBP-USD in our Hedgeye Portfolio via the etf FXB. We sold the position on 10/8 for a gain of +1.9%. We think that the big gain in the currency pair came in the month of September into early October (see chart below).