After Chancellor Philip Hammond announced a rise in UK government borrowing in his Autumn Statement, Edward Hutchings examines the potential impact on the bond market.

 

Philip Hammond’s first Autumn Statement was a sombre affair. The Chancellor of the Exchequer announced lower growth forecasts and higher government borrowing[1].

According to the Office for Budget Responsibility (OBR), the UK’s official independent fiscal watchdog, GDP growth in 2017 is likely to stand at 1.4 per cent, compared with its previous forecast of 2.2 per cent[2]. Growth over the next five years will be 2.4 per cent lower than previously thought, largely due to uncertainty surrounding the terms of the UK’s exit from the European Union.

The government will increase borrowing to cushion the blow. As expected, Hammond abandoned his predecessor George Osborne’s pledge to close the deficit by the end of the decade, although he did unveil a new draft Charter for Budget Responsibility. The charter commits the government to bring down national debt by the end of this parliament, to balance the books in the next parliament and to enforce a cap on welfare spending.

For the moment, however, debt is rising. For 2016-17, borrowing has been raised from £55.4 billion to £68.2 billion; over the next five years, cumulative borrowing will be £216.3 billion, £122.2 billion higher than projected. Hammond announced the national debt will rise from 84 per cent of GDP in 2015 and peak in 2017-18 at an eye-watering 90.2 per cent.

So how do bond investors view the sharp rise in the national debt? And how will the chancellor’s borrowing plans affect gilts? In this Q&A, Edward Hutchings, Senior Portfolio Manager, UK Sovereign, explores the implications of the Autumn Statement for the bond market.

 

How did the Autumn Statement compare with market expectations?

Going into the event, the consensus among investors was that the UK does not need a large fiscal stimulus package at this point – and with debt levels already high at 84 per cent of GDP, the Treasury needed be wary of compromising the ‘kindness of strangers’. So the outcome was more or less as expected with regard to the muted fiscal package. The UK government is not seeking a budget surplus in 2019-20, but the chancellor said both he and Prime Minister Theresa May remain firmly committed to balancing the public finances as soon as practicable, while retaining the flexibility to support the economy in the near term.

How will the chancellor’s borrowing plans affect gilt yields?

UK government bond issuance will total £152.1 billion this year, £20.6 billion higher than expected. Most of the extra issuance – around £15 billion – will take the form of gilts. As a result, the market may have to price in greater inflation and term premiums on gilts. Recent comments from the government and the Bank of England’s Monetary Policy Committee suggest that quantitative easing may soon be discontinued. Taken together, these developments may result in rising yields over the coming months.

How will international investors respond to the Autumn Statement?

UK public finances are not in great shape, what with the waning impact of monetary policy and the ongoing uncertainty surrounding ‘Brexit’. With this in mind, overseas investors may well come to see gilts as less attractive. However, this is not the case just yet. Overseas gilt holdings increased year-on-year by around 22 per cent up to the end of the second quarter. And Bank of England data shows foreign investors bought about £13.3 billion of gilts in September alone. This suggests there is still demand for UK government debt.

How do you expect gilts to perform relative to other government bonds?

Weighing the value of gilts against other government bonds is tricky. Yes, the UK will see a significant increase in gilt issuance in the wake of the Autumn Statement. Yes, quantitative easing could be discontinued in the first quarter of 2017. And yes, uncertainty remains over Brexit. Nevertheless, overseas fixed-income opportunities are not that enticing either.

In the US, the Federal Reserve is on the path to raising rates – albeit gradually – and president-elect Donald Trump is planning a large fiscal stimulus package, which could stoke inflation. This does not argue in favour of owning US Treasuries over gilts. Investors should also proceed with caution when it comes to European government bonds. Yields on Bunds are low, and political risk remains elevated across the EU, where a series of potentially pivotal elections will take place over the next twelve months. There is also talk the European Central Bank might taper its QE programme. While the outlook for gilts is challenging, there are arguably less attractive government bonds on a relative basis.

Will the chancellor’s borrowing plans affect the credit markets?

The bottom line is that the Treasury’s stance is now slightly more supportive for credit. For example, the focus on economic productivity – the chancellor announced a £23 billion national productivity investment fund to spend on infrastructure and research and development – will be beneficial. But this is no panacea. The reaction of the credit markets to the Autumn Statement has been relatively muted.


 

[1] https://www.gov.uk/government/publications/autumn-statement-2016-documents

[2] http://budgetresponsibility.org.uk/overview-of-the-november-2016-economic-and-fiscal-outlook/

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