Autumn statement 2016: will the sums add up?

Thinking Aloud

The EU referendum result casts a long shadow over the chancellor’s 2016 Autumn Statement, resulting in a surprisingly modest downgrade to the economy’s growth prospects but a sharp worsening of its fiscal outlook.

Within these tight parameters, Mr Hammond has done what he can: setting new fiscal rules, highlighting the UK’s long-term challenges, and raising modest additional revenues to address the concerns of the six million “just about managing” (JAM) households in whom Prime Minister Theresa May has shown a particular interest. Overall, the independent Office for Budget Responsibility (OBR) thinks the fiscal measures announced in the statement will add a minimal 0.1 percentage points (pps) to gross domestic product (GDP) growth in 2017-18 – so much for a fiscal reset.

The question is: will this approach work; and what will markets make of it?

Economic insight: fingers crossed

Mr Hammond didn’t need to pull a rabbit out of the hat – the OBR did it for him … Ahead of the Autumn Statement, the independent OBR had been expected to take a scythe to its forecasts for the UK economy over the next five years. In the event, it only nudged down its GDP growth projections for 2017 and 2018 (to 1.4% from 2.2%, and to 1.7% from 2.1%, respectively), leaving the outlook for the following two years unchanged at 2.1% in each. It also marginally upgraded its growth forecast for this year, to 2.1% from 2.0%, reflecting the resilience of confidence and spending in the post-referendum period. As a result, the OBR’s current view is that the referendum decision reduces the UK’s potential growth by ‘only’ 2.4 percentage points more than would otherwise have been the case – allowing the chancellor a little more policy wriggle room than he might have feared.

But the OBR is very uncertain about this outlook, stating that it is based on “broad-brush judgements consistent with a range of possible outcomes” … With these broad-brush judgements including that the UK leaves the EU in April 2019; that the negotiation of new trading arrangements with the EU and others slows the pace of import and export growth for the next 10 years; and that the UK adopts a tighter migration regime than that currently in place, but not sufficiently tight to reduce net inward migration to the desired ‘tens of thousands’. Will these judgements prove to be correct? We have no idea, given that they depend not only on the UK government’s own, as-yet-to-be-decided negotiating position, but also that of the other 27 EU member states – not to mention the global economic backdrop in place at the time. If there is one thing we have learned in the past year, events can very rapidly blow even the best thought-through forecasts off course.

And even with these relatively optimistic economic judgements, considerable fiscal damage is likely – and if the economic outlook sours, so will the finances … By the end of the decade, public borrowing will be £30bn a year worse on the OBR’s latest numbers, compared with the forecasts in the March Budget. Public sector debt is no longer expected to fall as a share of GDP this year; it is instead projected to rise to a peak of 90.2% of national income by 2017-18. As a result, the government will have to borrow over £120bn more than it had planned in the March budget over the next five years – worse than anticipated ahead of the Autumn Statement, despite the more positive growth outlook painted by the OBR.

In the face of these fiscal forecasts, Mr Hammond bowed to the inevitable and abolished his predecessor’s fiscal rules, announcing three new ones … First, the public finances should balance as “early as possible” in the next parliament, while in this parliament the cyclically adjusted deficit should be below 2% of national income. Second, the “burden” of public sector debt should be falling by the end of this parliament. Finally, there will be a new cap on welfare spending. Allowing more room to increase spending under the new more flexible fiscal rules makes sense, given the failure of previous rules either to be met or (as a result) to shore up previous governments’ credibility. Whether Mr Hammond’s rules will be any more successful – particularly against the uncertainties of the Brexit backdrop – remains to be seen.

Despite the constraints on the public finances, the chancellor made a welcome move to flag up the economy’s long-term problems – even if he doesn’t have the money to do much about them … Low productivity, poor infrastructure and a lack of affordable housing were all highlighted by the chancellor. We agree with Mr Hammond that raising productivity is “essential for a high wage, high skill economy”. The productivity gap is well known, but shocking nonetheless: as the chancellor pointed out, this effectively means that it takes us five working days to produce what a German worker makes in four. The chancellor’s announcement of a national productivity investment fund of over £23bn in the next five years is welcome, though will not on its own be enough to tackle this long-standing challenge. However, it is a step in the right direction. And the restatement of the government’s commitment to reduce corporation tax to 17% provides reassurance for business at a time of economic uncertainty.

And there was more than a nod to the JAMs in the Autumn Statement’s modest giveaways … As expected, the chancellor announced a rise in the national living wage to £7.50 from £7.20 per hour from April next year; a reduction in the universal credit taper rate from 65% to 63%; and he cancelled the fuel duty rise for the seventh year in succession. Nonetheless, JAM households will continue to feel the effects of the squeeze on departmental spending outlined by George Osborne back in March – for all the talk of a “fiscal reset”, austerity has not disappeared. Furthermore, with in-work benefits frozen in nominal terms until 2020 and the outlook for inflation now higher as a result of the post-referendum fall in sterling, JAM households’ incomes will be squeezed in real terms over this period. Whether today’s announcements will compensate in the minds of lower-income households is a moot point.

Given the bad news on the public finances, how will these measures – to address the economy’s long-term problems and to meet the needs of the JAMs – be funded?  Not to mention the fact that Mr Hammond also has to pay for the misjudgements of his predecessor, plugging a hole of around £1.4 billion a year resulting from the abandonment of cuts to personal independence payments. Additional infrastructure investment will be funded by higher borrowing, but Mr Hammond made clear that his day-to-day spending pledges will be funded by higher taxes. A rise in the insurance premium tax to 12% from 10% will be the single biggest earner, bringing in around £850 million a year from 2018-19. Significant sums are also projected to come from a clampdown on salary sacrifice schemes (around £235 million a year), increasing employers’ national insurance contributions (around £145 million a year) and various tax avoidance clampdowns.

So will the sums add up? If the economy copes as well with Brexit – whatever form it takes – as the OBR expects; if tax revenues meet expectations and there are no external shocks that require an unexpected offsetting pick-up in government spending; and if the government remains happy to go into the 2020 general election with a still-ambitious austerity programme in place, the numbers could add up. But our experience over recent years suggests that Mr Hammond is very wise to build in some flexibility. All told, the rules give him a further 1.2 pps of GDP to spend. He may well need it.

Market insight: more to worry about elsewhere

There was little in this statement to change significantly the views of investors in the UK equity, currency or, perhaps most importantly of all for the chancellor, debt markets.

The OBR economic forecasts noted above, while a little better than expected, nevertheless point to a worsening of the fiscal outlook. Gilts weakened slightly on the statement, with investors noting a higher borrowing requirement and the OBR’s increased uncertainty around its forecasts.

In aggregate, the statement will have little effect on a UK equity market that derives the majority of its earnings from overseas. However, there are a number of potentially more material changes that may have more significant consequences at company and sector level.

The chancellor reiterated the government’s plan to reduce corporation tax to 17% by 2020. Previous government pronouncements on corporation tax had sown doubts in the minds of some investors as to the chancellor’s commitment to this lower rate. His restatement will therefore be welcome, particularly at a time when we are seeing the prospects for lower corporation tax rates being discussed by the incoming US administration.

This was a statement that did not move markets significantly, an outcome that the chancellor is likely to be happy with.

The rate of insurance premium tax was increased again, to 12%. This is another significant rise and one that companies are likely to pass on to their customers.

The alignment of primary and secondary thresholds for national insurance is, in effect, an increase in taxation for the corporate sector (and indeed the government itself, as the country’s largest employer). However the full effect may be mitigated, depending on its impact on future wage growth.

There were various announcements addressing three of the chancellor’s principal areas of concern, namely productivity, infrastructure and housing. These included the development of a National Infrastructure Fund and a Housing Infrastructure Fund. Such plans are obviously longer term in nature and “the devil is likely to be in the detail”. Investors will look closely at this detail, as it becomes available. However, the thrust of policy in these areas is clear. These are therefore themes that are likely to frame future pronouncements from the chancellor.

As regards the savings markets, the chancellor’s announcement of the new National Savings Investment Bond is likely to prove popular, given low returns available elsewhere. It also acknowledges the difficulties that savers continue to face in a low interest rate environment.

This was a statement that did not move markets significantly, an outcome that the chancellor is likely to be happy with. It is also a statement delivered in the context of a global economy with significant economic and political uncertainty, both at home and abroad. As a result, events beyond those mentioned at the dispatch box this afternoon are likely to have the greatest impact on UK markets, in all their forms.

The above article by Lucy O’Carroll, Chief Economist, Investment Solutions at Aberdeen Asset Managers Limited, originally appeared on the Aberdeen Assest Management ‘Thinking Aloud’ blog on 23rd November 2016