Rabbit Time

Global equities were mixed last week. In local currency terms, they continued their recovery with a gain of 0.8%. But they lost 0.5% in sterling terms as the pound strengthened 1.5% against the dollar to $1.26.

Meanwhile, government bond yields edged higher, reversing some of their recent fall. The increase was led by the UK where gilt yields rose around 0.15% on the back of the Autumn Statement.

In a week foreshortened in the US by the thanksgiving holiday, the main focus for UK investors was Jeremy Hunt who managed to pull a few rabbits out of the hat.

Rather than cut income tax as anticipated, the Chancellor announced a larger than expected cut in National Insurance, notably a reduction in the main NI rate from 12% to 10%. This will end up costing by 2027/28 some £10bn per year. He also made permanent the current rules allowing businesses to fully expense investment against tax, in what he claimed was the biggest business tax cut ever, also at an eventual cost of around £10bn.

These crowd-pleasing tax cuts were made possible because high inflation had boosted government revenues and given the Chancellor some £30bn leeway to hit his fiscal rules. Most important of these is the requirement for government debt to be falling as a share of GDP in five years’ time. Still, two factors took some of the shine off this tax-cutting coup.

First, even with these cuts, the tax burden is still forecast to rise further over coming years to an all-time high of 37.4% of GDP. This is largely down to the so-called stealth tax increases brought about by the freezing of income tax thresholds at a time of high inflation.

Second, the Chancellor was only able to cut taxes because he did not increase government spending to reflect the higher inflation. This now leaves departmental spending forecast to fall in real terms over the next few years which will be a major headache to implement, whichever Party wins the next election.

Overall, these measures will slightly reduce the drag on growth this coming year from fiscal policy. The Chancellor has supposedly introduced as many as 110 growth boosting measures. But while a welcome attempt to boost the supply side of the economy and its worryingly low trend growth rate, the reality is that their near-term impact will be small.

Tax cuts may also make the Bank of England a bit slower to start cutting rates. Indeed, the markets have scaled back a little their expectations on this front. They now expect rates to begin falling next summer and to be down 0.5% by year-end.

The slightly stronger growth outlook was supported by the latest UK economic releases. Business confidence, which has been languishing in recession territory since the summer, recovered a bit in November and is no longer flagging a recession. Consumers also turned a tad more optimistic this month.

All said and done, the economy now looks set to grow a modest 0.5% or so next year, a similar performance to this year. While hardly reason to break out the champagne, this is a whole lot better than the recession which had been widely forecast a year ago. This, along with the prospect of rates remaining higher for slightly longer, was behind last week’s increase in gilt yields and strengthening of the pound.

As for UK equities, the Autumn statement had no major impact with large, mid and small cap stocks all ending the week down fractionally. The UK remains one of our favourite markets as valuations continue to look excessively cheap across all these areas. With recession now looking avoidable and rate cuts coming onto the horizon, the greatest opportunities seem to lie with small and mid-cap stocks with their greater domestic focus.

Rupert Thompson – Chief Economist