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Positions in Europe: Long British Pound (FXB); Short Spain (EWP)


Below we update our outlook on the UK economy in light of Chancellor of the Exchequer George Osborne’s 2011 Budget release last week. We believe that the budget largely stays the course on deficit spending, which should be a bullish catalyst for the GBP-USD and continue to support the country’s credit market outperformance; however, we caution that the decision to raise taxes on energy producers is a competitive drag worth consideration. We continue to believe that while the UK’s austerity programs are positive for its longer term economic outlook, over the near to medium term we expect the UK economy to underperform its fiscally stronger European peers (Germany, Sweden, Poland).


Budget Direction


Last Wednesday Osborne presented the UK’s 2011 Budget; notably the budget stayed the course on deficit spending and emphasized making the UK a more competitive country by attracting investment and promoting a higher skilled and better educated work force.

Very plainly Osborne addressed the ails of the economy and its peoples, recognizing that:

  • Higher food and energy prices are squeezing consumers (unlike The Bernank) and relief must be given. He offered marginal income tax reductions (primarily for low income earners and a child tax credit) and relief at the pump by cutting the fuel tax by one penny per liter this year.
  • The UK has dropped from 4th to 12th place in the global competitiveness league, and therefore he offered:
    • Funding for 12 new University Technical Colleges
    • The creation of a new work experience program to benefit  20K young people and funding for 40K new apprenticeships to tackle youth unemployment
    • To improve competitiveness Osborne also called for a reduction in the corporate tax rate (currently the 6th highest in the world) starting this April by 2%, and by 1% in each of the following three years.  (Effectively from 28% to 23% over 4 years)

On economic fundamentals, Osborne noted:

  • Annual GDP for 2011 will be revised down to 1.7% versus the previous estimate of 2.1% and improve to 2.5% in 2012.
  • Inflation is expected to remain between 4-5% for most of 2011, before dropping to 2.5% in 2012.
  • The country stands for credibility on the global marketplace, with 10YR interest rates at 3.6%, near Germany’s rate, and far from the 12.5% in Greece or 10% in Ireland.

On taxes of oil production profits in the UK:

  • Osborne called for profits to be taxed at 62% from 50% to pay for a lower consumer tax on gas.
  • The supplementary charge levied to oil and gas production was raised from 20% to 30%.

Overall the tone of the budget was positive: Osborne sized up the country’s growth deficiencies and proposed measures to return the country to a more competitive state. However, on the point of taxing profits of oil companies invested in the UK, we caution that Osborne may be swinging the pendulum too aggressively in requiring oil companies to subsidize gas prices in the present environment of inflated energy prices. 

And the repercussion of this decision may be more than Osborne had in store. Yesterday, Statoil put on hold a $10 Billion plan to develop the Mariner and Bressay fields in the UK, with CEO Peter Mellbye saying the new taxes are “tremendously negative” and that he’ll have to reconsider the project.



Fundamental Landscape


Of the high frequency data we follow, we’ve not seen any major inflection points from trend in the UK data over the last months. The final reading of Q4 GDP was -0.5% quarter-over-quarter and the most present threat to future numbers remains inflation, which, as reflected by the CPI, continues to trend higher.  The most currently February reading is +4.4% Y/Y.  PPI input costs are running at 14.6% Y/Y, suggesting that these costs too must be passed on to the consumer.  The BoE continues to remain in the precarious situation that it needs to act to combat inflation by raising rates, however fears that a hike could stymie growth. At present, the BoE continues to lean dovish on a hike. 

UK retail Sales fell 80bps in February versus the previous month, which we think is representative for the months ahead now that we are out of the holiday period and the consumer is faced with a higher VAT (see chart below).

We’re seeing confirmation of this malaise vis-à-vis consumer confidence surveys.  According to Nationwide, consumer confidence fell to 38 in February versus 48 in January, which is the lowest reading since the survey began in 2004.

On the unemployment picture, the rate continues to tick higher, adding 10bps month-over-month in January to 8.0%, however the jobless claims figure improved remarkably, falling 10K versus expectations for a 2K gain in February.

The housing market data also fails to impress across multiple surveys.


GBP and Gilt Strength


Despite our negative outlook on the UK economy over the intermediate term, we continue to see strength in the GBP-USD and the credit market which we think is a function of the UK’s fiscal sobriety to issue austerity and cut the deficit versus, in particular, the US’s fiscal irresponsibility and USD debauchery.  We’re currently long the currency via the etf FXB. We covered our short position in Italy (EWI) today and remain long Spain (EWP) in the Hedgeye Virtual Portfolio.

Matthew Hedrick


Osborne’s 2011 Budget and UK Outlook - retail sales uk