The Ghost of [Mini] Budget Past
Rachel Reeves will deliver her budget next week and, as widely discussed, she faces a daunting challenge: a fiscal black hole estimated at around £30 billion.
In positioning this bad news, expect Labour to attribute it to 14 years of Conservative governance, while the Tories will respond that the blame lies squarely with the Chancellor, with the changes to National Insurance contributions and the raised minimum wage levels of last year’s budget considered major impediments for business.
There is at least some truth in both these claims, but a significant share of responsibility also lies with the Office for Budget Responsibility (OBR). For years, questions have been raised over the OBR’s productivity growth forecasts, which have often outstripped the expectations of other economic forecasters, yet actual growth has regularly disappointed. These misjudgements have allowed previous chancellors to spend more or tax less than should have occurred. It seems that this mistake will now be rectified, with next week’s budget expected to reflect the OBR’s new, lower trend productivity growth forecast.
Lower growth projections mean it is harder for Reeves to make her sums add up. Greater borrowing would be an alternative option, but the ghost of Liz Truss’s ill-fated mini-budget looms large. Her unfunded tax cuts triggered a gilt and sterling sell-off, a stark reminder that “bond vigilantes” will not tolerate fiscal recklessness.
For Labour, it would be unfunded spending rather than tax cuts that could spook the markets, yet the outcome would likely be similar. It is in response to this risk that Reeves has been adamant about her “ironclad” fiscal rule, promising that day-to-day spending will be met by revenues within five years.
Avoiding excessive borrowing is a policy choice designed to keep the markets on side, and so far it has worked. The downside is that it limits her options to spending cuts or tax rises, and Labour backbenches have shown their feelings on the former, having forced a U-turn on the government’s attempt at welfare reform. It is because of all this that Rachel Reeves will stand at the dispatch box next week and once again set out a tax-raising budget.
Trump 2.0 – The Market Impact
Stock markets experienced a sharp sell-off in April this year following Donald Trump’s “Liberation Day” tariff announcements, but since then strong growth has occurred. A surge in US technology stocks is one factor in this, but high growth in Asian and Emerging Markets has also occurred, benefitting in part from resilience in the Chinese economy. With China appearing to be the primary target of Trump’s tariff aggression, this is perhaps surprising.
The positivity has occurred in part because Trump’s bark has proven worse than his bite. While US trade tariffs briefly spiked to an effective rate of 25%, they have since eased to 16% – still the highest since the 1930s, but less severe than feared. China has seemingly weathered this storm well. Exports to the US have dropped dramatically this year, but these have been more than offset by greater international trade elsewhere. Meanwhile, Western central banks have lowered interest rates. These rate cuts have been stimulatory for these countries’ domestic markets, but additional benefit has come from the weakening of the dollar that accompanies US rate cuts. This has been a further fillip for emerging markets, where a cheaper dollar has many benefits, with lower commodity prices and funding costs the main examples.
The UK budget is unlikely to have a major impact on the direction of global markets, but the strong performance of recent months and the impact of the AI boom could well shape the direction of travel from here. So, what are the challenges and opportunities ahead?
Challenges
AI enthusiasm has propelled US and some Asian markets higher, but caution is warranted. So far, the gains have been concentrated in a handful of tech giants, but if AI fulfils its promise of greater productivity throughout the economy, then the lasting winners will likely be beyond Big Tech. With valuations already stretched in many of these companies, are the benefits already largely ‘priced in’?
A study by the economist William Nordhaus estimated that in the US from 1948–2001 just 4% of the benefits of an innovation went to the corporation behind the idea, with 96% going to wider society. If the current scenario holds any level of similarity to this, then the real long-term winners of AI may not be those current front runners.
In the portfolios managed by Future Money, we maintain high levels of diversification with the aim of capturing the long-term value of this technological development while reducing the risk of unsustainable valuations.
Public debt levels are another challenge for society. Governments are forced to allocate increasing portions of their budget to pay the bills on historic debt, as higher interest rates over recent years make refinancing a daunting task. In the UK, this brings us back to Reeves’s fiscal dilemma and her desire to keep the markets happy. In the US, however, little worry is given to the subject.
President Trump’s funding plans (his “One Big Beautiful Bill”) promise sweeping tax cuts, yet he argues this is sustainable as tariff revenues will offset the deficit it creates. Markets have tolerated this so far, but the sums are questionable. The risk of a bond market backlash at some point in the coming years should not be ignored.
And Opportunities
Despite these risks, opportunities persist. A further interest rate cut is expected from the Bank of England in the coming weeks, and another one from the US Federal Reserve would not be a surprise. This prospect will be welcomed by markets, but the latent effects of previous rate cuts are another factor which supports further positivity from here.
There is often considered a lag of approximately 18 months from the point of a change in interest rates to its full force being felt by the economy. While UK interest rates are now at 4%, 18 months ago they were still at the peak of this cycle, at 5.25%. As such, conditions in the UK economy are tighter than they will be and, as this feeds through to the economy, this monetary loosening should provide a positive factor for investors.