Supermassive Black Hole

Labour’s fiscal black hole could be growing. Even before Labour won the general election, Chancellor Rachel Reeves had slightly boxed herself into a corner by self-imposing new fiscal rules. This was an ‘ironclad’ commitment to reduce government debt. However, this will restrict her ability to avoid tax increases or public spending cuts.

On coming into office, the new Chancellor announced that she had found a £22bn ‘black hole’ in the UK’s public finances and ‘had to act to fix the mess.’ So far, measures include the means testing of winter fuel payments for pensioners, the axing of £1.3bn of investment in an AI fund, delaying some infrastructure projects, and a warning of some tax increases in the October Budget.

However, when it comes to black holes, the Chancellor’s method of measuring UK debt will now be key. This is because there are potentially two measures – public sector net debt and that excluding the Bank of England (BoE).

Why does this matter?

The 2008 financial crisis seems like a long time ago, but its legacy is still with us. The then Chancellor, Alistair Darling, announced that the Government had authorised the Bank of England (BoE) to start a policy of Quantitative Easing (QE), to help stimulate the UK economy.

Over the next decade or so, the BoE bought hundreds of billions of pounds of government bonds (gilts). The BoE is now undertaking the opposite, Quantitative Tightening or QT – shrinking its balance sheet by allowing gilts to mature or selling them to institutions. Unfortunately, in a higher-for-longer interest rate world, gilt yields have risen, and the BoE’s most recently updated guidance suggested a potential unrealised QE loss of £100bn, although some economists believe this could be closer to £200bn! If the Chancellor opts to measure UK debt excluding the BoE, she may have found £16bn of fiscal ‘wriggle room’.

The Labour government has said it will not increase income tax, National Insurance or VAT. However, CGT rates could be increased, pension tax relief changed, and inheritance taxes raised. The scale of these will depend on the UK debt measurement.

Politicians are well known for making U-turns. Having said that, there would be no tax increases or public spending cuts – non-mainstream taxes are going to increase, while some government departments are being asked to identify ‘efficiencies.’

Could the Chancellor make a U-turn on the interest the Bank of England pays on the deposits from the high street banks? This is currently 5% on an estimated £700bn costing £35bn. Some argue the Chancellor should copy the Bank of Japan or European Central Bank and have the BoE offer a system of tiered interest rates. We will have the answers in October’s Budget.

If Rachel Reeves thought the £22bn black hole was bad, what does she make of the £100bn BoE QE ‘black hole?’ As ever, an accounting fiddle that many of the British public would not understand may provide her with a ‘get out of jail card.’

Either way, tax rises and public spending cuts look here to stay.

 

What have we been watching?     

Following the recent Japanese ‘carry trade’ driven sell-off, a measure of calm returned to markets last week, where the focus turned to US economic data with one eye on events in the Middle East. The latest US inflation data would appear to give the green light for the US Federal Reserve (Fed) to cut interest rates in September although there is still some debate about whether this will be by 0.25% or 0.5%. US retail sales also rose more than expected in July, providing further comfort about the US economy. Investment house Goldmans lowered the chance of a US recession from 25% to 20%. The US 10-year Treasury yield dropped back below 3.9%, while NASDAQ has rallied 11% although it is still 6% below its recent peak.

Israel’s defence minister told his US counterpart that the country is preparing for a large-scale military attack from Iran. The Biden administration is seeking to avoid an escalation of the conflict in the Middle East and is endeavouring to get a ceasefire agreed between Israel and Hamas.

Ukrainian forces have continued their advance into Russian territory, and a state of emergency has been declared in Belgorod.

The trade ‘Cold War’ continues with China restricting the export of more key rare metals. The latest is antimony, which is used in alloys, and follows similar restrictions on gallium, germanium, and high-grade graphite.

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UK unemployment dropped to 4.2% in the three-months to June, while wage growth slowed to 5.4%. Meanwhile, food inflation ticked up slightly to 1.6% in the four weeks to 4^th August. CPI figures for July showed an increase in inflation to 2.2% in June but this was slightly less than had been expected. More significantly, for the Bank of England (BoE), service sector inflation slowed from 5.7% to 5.2%. A September interest rate cut is still debatable, but a 0.25% cut in November to 4.75% looks odds-on. However, Cornwall Insight is forecasting energy prices will rise by 9% in October -not welcome news for the BoE.  Meanwhile, the UK economy showed no growth in June although some industries were affected by the general election. UK GDP for the second quarter slowed to 0.6%.     

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The US Producer Prices Index, (PPI) increased in July by 0.1%, slightly lower than expected, while core PPI, excluding food and energy was unchanged on the month. US CPI rose 0.2% in July to 2.9% in line with expectations, keeping the Fed on track for an interest rate cut in September. US retail sales rose by 1% in July, which was better than expected.     

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Japan’s economy grew by 0.8% in the second quarter, which was slightly better than expected.

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China’s retail sales rebounded in July, growing by 2.7%; however, industrial output slowed to 5.1%.

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Brent oil drifted back below $80 despite concerns about a possible retaliatory military strike by Iran against Israel. This was because OPEC reduced its global oil demand forecast for 2024 by almost 7% to 2.1million barrels a day and cut that for 2025 by about 4% to 1.78m.

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Finally, for small businesses, nothing beats free publicity! Banksy has been delighting fans with his animal stencils across London. This included the artwork of two pelicans eating above the sign of Bonners Fish Bar in Walthamstow. The owners must be over the moon with the media coverage, social media postings and footfall. What next? Perhaps an image of the artist himself on the wall of the old lady of Threadneedle Street? – The Banksy of England?

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Read Last Week’s Alpha Bites – Go for broke

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Alpha Portfolio Management is a trading name of R C Brown Investment Management PLC which is authorised and regulated by the Financial Conduct Authority.