Striking the Right Balance: The Budget and Investors’ Reaction

This week Chancellor of the Exchequer Rishi Sunak delivered the government’s taxation and spending plans for the next financial year.

The backdrop could hardly be more challenging with the total monetary value of the UK’s borrowing to deal with COVID-19 estimated at a whopping £355 billion; six times higher than the level forecast during last year’s Budget. Public borrowing is at its highest peacetime level as a proportion of Gross Domestic Product, as shown below in percentage terms. The dashed line at the edge of the graph denotes the fact the figures produced on Wednesday are a projection, while the orange line represents the forward estimates made during the 2020 Budget.

Graph 1: UK public borrowing as a percentage of GDP

Source: Office for Budget Responsibility, data as of March 2021

The chart above makes for sober viewing, but, in recognition of the unique circumstances created by COVID-19, the Chancellor outlined policies to ensure the UK’s economic performance returns to growth before dealing with the now swollen deficit. Essentially, spend now tax later. Although we will see a reduction in public borrowing this year, it will remain high at £296 billion and more than previously expected.

For a more in-depth insight into the Chancellor’s fiscal plans, we have produced a video and descriptive explainer of the changes, which can be found here.

In this piece, we assess the Budget’s economic projections and investor reactions below.

The Economic Impact

Aside from changes to taxation, the Chancellor provided updates to economic forecasts made back in November at the time of the autumn statement. Thankfully, the picture painted on Wednesday indicates a somewhat improved economic environment than forecast in November. Accordingly:

1. The Office for Budget Responsibility anticipate a swifter and more robust economic recovery with Gross Domestic Product (GDP) returning to pre-crisis levels by Q2 2022, 6 months earlier than previously forecast.
2. Peak unemployment of 6.5 per cent versus their prior forecast of 7.5 per cent helped by the furlough scheme extension. The scheme extension avoids a cliff edge, ensuring borrowing will not be as bad as feared but still high exceptionally high by historical standards.
3. The latest lockdown has pulled down forecast economic growth for 2021 from 5.5% to 4%, but growth for 2022 will accelerate to 7.3%, an improvement from the 6.6 % growth rate estimated previously for 2022.
4. Finally, the lockdown policy’s overall effect is long-term economic scarring of 3 percent, highlighting the economic destruction wrought by the virus. Given the pandemic’s global nature, the fiscal actions taken, and the continuing support offered, the scarring effect isn’t as bad as feared. It provides greater hope for economic recovery.

Market Reaction

Overall, the market reaction to the Budget was relatively muted; partly a consequence of press leaks ahead of Wednesday’s speech and partly an acknowledgement that the Chancellor has not taken undue risks with the public finances or tightened spending so much as to stifle the recovery.

Fixed income markets reflected modest changes in expectations.

Graph 2 below shows the reaction of gilt (UK sovereign debt) markets to the speech’s announcements. The chart displays the response of both the 10-year and 30-year gilt yields on Wednesday, with the 10-year yield plotted on the left y-axis and 30-year yield charted on the right y-axis.

Remember, bond yields and prices have an inverse relationship, with rising yields indicative of falling bond prices and therefore a reduction in investor demand. As observed in the graph below, yields on 10-year gilts rose to 0.79%, while the yields on 30-year gilts increased to 1.36%.

Graph 2: UK 10-year and 30-year Gilts yields

Source: Bloomberg, data as of 3rd of March 2021

The drop in bond yields evidences two things:

1. As mentioned above, the government is forecasted to borrow significantly more in the coming financial year than thought just a few months ago. Therefore, more near-term supply is pushing down the price of existing gilts.; and
2. Inflation expectations have been picking up slightly in response to continued fiscal and monetary stimulus as the economic recovery gets underway. It should be stressed that this shift is modest and from a low base. Consequently, holders of longer-term maturities have seen prices fall more and explains why the yield of the 30-year gilt is now higher than medium-term 10-year maturities.

It is essential to stress the UK government’s borrowing costs are still meager by historical standards. Rising yields are also an indicator of more confidence in the UK’s economic growth trajectory.

In conclusion, the Chancellor has attempted to walk a thin tightrope between repairing public finances and providing enough stimulus to embed the recovery. The generally mild reaction within Fixed Income markets show that he has struck the right balance.