One done, one to go
Well, despite its supposedly momentous nature, the market reaction to the UK budget was actually pretty limited. UK equities ended the week down 1.0%, similar to the decline seen in global markets. The pound was also largely unmoved, ending little changed at $1.30.
UK gilts, however, did lose 1.7% over the week as a result of a 0.2-0.3% rise in yields. While some of the increase just echoed a rise in US Treasury yields, part can be laid at the Chancellor’s door. That said, the budget-related sell-off is relatively small and has caused none of the trauma associated with the Liz Truss mini-budget.
We won’t go into big detail as more than enough has already been written on the subject. At the end of the day, what with all the leaks, there were no major surprises. The £40bn rise in taxes was largely as trailed, although a larger than expected £25bn of this is to be borne by employers through higher national insurance contributions. The tax share will rise to a record 38% of GDP and rather closer to Continental European levels.
Meanwhile, public spending was raised by £70bn. While most of the increase was on day-to-day spending, capital spending is also to be raised £100bn over the life of the parliament and the fiscal rules were altered to accommodate this.
The net effect will be to boost the budget deficit over the next five years by an average £30bn or so. Even so, it is still forecast to decline from 4.7% of GDP last year to 2.1% by 2029. By way of comparison and some reassurance, the US is expected to be running deficits in excess of 6% of GDP for the foreseeable future.
As for the new economic forecasts of the Office for Budget Responsibility, they show growth picking up to 2.0% in 2025 before slowing back to 1.5% further out. Given the universal belief that renewed growth is essential to cure the UK’s problems, its muted longer term growth forecast despite the increased investment was disappointing. On the inflation front, the OBR sees it rising again to 2.6% next year before slowly returning to 2%.
The bottom line is that the budget does not really change the story for UK equities with their main attraction remaining their cheap valuation. Their price-earnings ratio is currently a lowly 11.5x, 15% below the historical average. Within the UK, small and mid-cap remain our preferred area as they are particularly cheap, the pick-up in growth should be positive, and the rise in capital gains tax and clamp down on the tax benefits of holding AIM stocks were smaller than feared.
As for gilts, the small rise in yields seems appropriate. Inflation and growth are now forecast to be a little higher which may at the margin make the Bank of England a bit more cautious about easing policy. Still, the BOE looks almost certain to reduce rates by a further 0.25% to 4.75% on Thursday. We continue to believe UK bonds look quite attractive with gilts and corporate bonds yielding around 4.5% and 5.7% respectively and cash likely to be paying no more than 4% by next summer.
That’s more than enough on the UK. Elsewhere last week, the main macro news was in the US. Payroll growth slowed sharply in October and by more than expected. But with hurricanes and strikes largely to blame, this did not reignite the recession worries which previous big misses on payrolls have triggered.
Even so, the numbers make it even more certain that the Federal Reserve will cut rates this Thursday, albeit only by a normal 0.25%, rather than by 0.5% as in September. By then of course, we should – although this is far from guaranteed – know the result of the US Presidential election. Trump remains the favourite at this stage although it remains far too close to call, particularly as the polls over the weekend showed some move back towards Harris.
If Harris wins, the reaction might well be a collective yawn, except for the fact that any victory would no doubt be very close and subject to vehement challenge by Trump and his supporters. She would be very unlikely to gain a clean sweep (ie the Democrats control Congress as well as the Presidency) severely limiting her ability to enact her plans to cut taxes and increase spending.
If Trump wins, the market reaction is more uncertain. Again, it will partly depend on whether he gains a clean sweep which is more likely for Trump than Harris. If he doesn’t, this would constrain his room to cut taxes but not alter his ability to increase tariffs. A Trump victory is likely to lead to a rather stronger dollar and higher government bond yields because his plans to raise tariffs sharply would boost inflation and reduce the willingness of the Fed to reduce rates.
But growing expectations of a Trump victory have partly been behind the rise in the dollar and US Treasury yields in recent weeks, so some of this will already be in the price. The effect on equities is less clear cut. Although his plans for lower taxes and more deregulation will be viewed positively, his proposal to hike tariffs is more problematic given its impact on inflation and the danger of triggering a trade war.
Payrolls and the US election may have been centre stage last week but the results of Alphabet, Amazon, Apple, Meta and Microsoft were also a major focus of attention. And truth be told, they did little to resolve the debate over whether or not AI-hype has pushed these companies up to undeservedly high valuations.
While their third quarter results generally beat expectations, helping in the process to drive up anticipated earnings growth for the S&P 500 overall to 8% this quarter, their guidance was viewed less positively. Further massive AI-related investment is planned but the size and timing of the payback on this investment remains unclear. The Magnificent Seven ended the week down 1.7%.
We billed last week as a big one for news but it is dwarfed by this coming one with the US elections on Tuesday and the Fed and BOE meetings on Thursday. In addition, Friday should see China announce details of its fiscal stimulus plans which will be key in determining the direction of the next big move in that equity market.
Rupert Thompson – Chief Economist