Why the UK’s Autumn Budget is a global litmus test

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  Chancellor Rachel Reeves has been called to deliver a turn in British finances and better growth prospects. Reeves has gone to great lengths to hint her intentions for fiscal expansion to the press, in hopes of reducing the possibility of a market rebuke.

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  Overall, developed market governments have opted towards fiscal expansion in the past few years. Debt is very high. Coupled with inflation and interest rate uncertainty, bond markets have become anxious.

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  If there’s one thing markets hate more than an expansive Autumn Budget, it is a surprisingly expansive Autumn Budget.

The Autumn Budget

Ahead of tomorrow’s Autumn Budget, Commons Speaker Sir Lindsay Hoyle rebuked Chancellor Rachel Reeves for discussing the Autumn Budget with journalists before the House of Commons.

Her move breaks with protocol and the experienced parliamentarian’s scolding to the new Chancellor is probably part of his job, but in the Age of Debt Ms Reeve’s approach of testing the market waters before a big Autumn Budget (the first labour Autumn Budget since March 2010) makes absolute sense.

If there’s one thing markets hate more than an expansive Budget, it is a surprisingly expansive Budget. Recent history, the cautionary tale of Kwasi Kwarteng’s Autumn Budget that brought down Liz Truss’ new government in October 2022, explains exactly why big surprises are likely to be ’leaked’ to markets before they are brought before the Chamber. Since that woeful day, which humbled and brought down a new Prime Minister, Autumn Budgets have been extremely cautious.

Labour has made generous fiscal and at the same time growth promises, that can only be covered by incurring more debt. Hence Ms Reeves’ move to classify student debt as an asset rather than a liability (which may imply that debtors are actually on the hook for it), to gain a £50bn space in the Autumn Budget.

The question is, will the markets go for it, or will Mr Kwarteng’s story repeat itself? The first step to avoid disaster is to test the waters.

Ms Reeves seems pragmatic enough, understanding that the true test of the Autumn Budget will not be her own party’s MPs, with a strong 78-vote majority, or the British Parliament as a whole, or even the Office of Budgetary Responsibility (OBR). Rather it is financial markets. As such, the notion of a sealed box containing surprises for everyone to be presented first in Parliament is not only outdated but potentially inflammatory for the economy.

It is a challenge when a new Chancellor is presenting an Autumn Budget. An even bigger one when it is on behalf of a completely new government, especially from a party known for fiscal expansion. The level of difficulty is further raised by the fact that bond markets have been especially jittery in the past few weeks, as traders find themselves needing to readjust their rate expectations for the US, in light of stronger growth data.

The Fed may have erroneously emitted too dovish a signal with the double rate cut in September. It is now trying to double back, but it has already caused much frustration in Financial Markets which have transitioned from casually pricing in a multitude of rate cuts to ’not certain anymore’. As a result, global yields have been rising. For the UK, the 10y yield has risen by half a percentage point in just a month and a half, to 4.25%.

We live in an era of rapid debt accumulation. Global debt-to-GDP has risen from 220% to 327%. Government debt is now the highest portion of that.

France, the Eurozone’s second-biggest economy, has long flaunted EU fiscal stability rules and now finds itself with higher sovereign spreads than Spain and under warning from Brussels. Markets are also worried about Germany itself, which might be in a much better fiscal position, but it is a question whether its ailing economy can lift the weight of the Eurozone coming under renewed pressure.

In the US, the present administration didn’t seek to correct the fiscal excesses of the previous one but rather doubled down on them. The next administration, whoever wins, is projected to match or exceed the fiscal profligacy of its predecessors.

As a result, the world’s strongest economy is projected to pay at least 4% of its GDP in interest payments for the next few years, when that GDP isn’t forecasted to grow beyond 2.5%. The UK is in a similar position, paying 3.5% to 4.5% of GDP in interest payments, with GDP growing by an average of just 1.3% in the next two years. So governments will have to pay for loans more than they grow GDP each year.

Bond investors understand how unsustainable that is, and traders stand ready to ’punish’ those who will ignore their concerns. Hence the name ’bond vigilantes’. For years they have been kept at bay by dovish central banks. The reappearance of inflation has made central banks more apprehensive about printing money at the pace of the previous decade. Combined with climbing debt, their presence means higher risks for debt markets.

Since the Chinese invented paper money in the seventh century, the boom-bust cycle of debt has repeated itself, always and without fail. Each time, there’s a legitimate excuse why ’this time is different’, only to end up in a bust and the adoption of a harder measure of money, usually Gold, along with the promise not to do it again.

The limitations of global reserves of gold worth less than $22tn (including proven reserves) supporting a global economy of $100tn, don’t preclude a reckoning at some point, a debt endgame. And the telltale sign of that endgame approaching is the faster accumulation of debt. As countries struggle with ailing demographics (higher average costs especially around healthcare), lower productivity, geoeconomic disruptions, old infrastructure and the green transition, the only way to maintain their level of comfort is to borrow.

Presently, all major economies play a game of roulette. They fire, pushing their debt limits even further, and hope that the chamber (a market event) is empty. To be fair, this is not an even game of chance. The US can bank on the strength of its global reserve currency status. France and the UK on their G7 status and the strength of their central banks. China on its massive reserves and the size of its economy. The sense of urgency is low, as equity markets, propelled by the AI and pharma trades, are at an all-time high. Bond market jitters tend to cause less political consternation, and downside, than stock market panics, unless spreads shoot up violently.

What does it all mean?

For governments, especially new ones like the UK Labour government, it means that unfettered fiscal expansion is a dangerous game. Shifting the accounting rules is a very old practice and might be less effective at a time when bond markets are paying close attention. Peeking through the bullet chamber to see if it is empty, which is what Ms Reeves is doing, is by no means an insurance, but at least a modicum of precaution. Ultimately, however, governments will need to figure out ways to significantly improve productivity if they are to maintain their citizens’ way of life.

For businesses, it means that the era of macroeconomic volatility will likely persist. Larger businesses, with good corporate treasuries, need to make sure they remain diversified in terms of currency and assets. They also will need to consider how much they are willing to pay to smooth cash flows, given that interest rates aren’t going back to zero anytime soon. Smaller businesses may have to be careful with debt accumulation. Unlike governments, they can’t print money to pay it off. Insolvencies in Germany and the US are already on the rise.

For consumers, it means that financial planning will be more difficult. Markets will balance between higher inflation (due to debt) or deflation (if Chinese growth stalls), between higher rates (again due to debt and inflation) and much lower, at the cost of an economic crisis. Big investments (home, university) might have to be thoroughly planned years before execution.

Maintaining the primacy of Parliament, any parliament, is very important and not just a matter of decorum. But as all governments are finding out, keeping an eye for bond vigilantes is simply necessary for their survival. Britain will serve as another litmus test as to how much debt bond markets are willing to accept.

Investors need to keep an eye on two things this week: US payrolls and core personal consumption expenditure, the Fed’s favourite gauge of inflation. Strong employment and persistent inflation could push rate-cut expectations even further and exacerbate bond market volatility. Conversely, weak employment and lower inflation could boost hopes for rates to come down sooner and provide a reason for a bond market rebound. Major market action will be deferred, somewhat, ahead of the US election on 5 November.

British investors will be additionally laser-focused on the Autumn Budget. As we explain in this note, a non-market event is what Rachel Reeves is hoping for, and quite possibly (albeit never assuredly) what she will get, as she has communicated her intentions well in advance. A spike in UK yields, despite the early information campaign, could mean that markets are becoming wary of Britain’s fiscal position.

Market update

Global stocks fell by -0.9 % this week as markets priced in milder expectations for rate cuts by the Federal Reserve. UK, EU, emerging markets and Japanese equities underperformed the world index, falling by -1.3%, -1.0%, -1.4% each, while US stocks fell slightly less, by -0.3%, snapping a six-week streak of gains. Information technology and consumer discretionary were the only positive sectors in the US market. Earnings from major companies influenced broader market returns as well this week as big tech and industrial names reported last week.

Bond yields increased across the board on lower rate cut expectations, with US 10-year yields rising by 16 basis points, UK gilts rising by 17 basis points, and German Bunds rising by 11 basis points.

Gold rose by +1.7% while oil rose by +3.9%

Macro news

UK economic growth will accelerate this year and next, as falling inflation and interest rates strengthen domestic demand, the IMF has said on its October World Economic Outlook update. The UK economy is projected to grow by 1.1% this year — a 0.4% upgrade on its April forecast. The projection for 2025 remained unchanged at 1.5%.

The IMF's World Economic Outlook 2024 forecasts global growth at 3.2% for 2024-2025, stable but below pre-pandemic levels. Inflation is expected to decrease to 3.5% by end of 2025 from a peak of 9.4% in 2022. Key risks include geopolitical conflicts, monetary tightening, possible Chinese economic slowdown, and rising protectionism, posing threats to trade and financial stability.

The week ahead

For UK investors, all eyes will be on the budget this week. Chancellor Rachel Reeves is due to deliver her Autumn Budget speech at 12:30 tomorrow.