PIMCO: What investors should know about the UK budget
While the Chancellor met her fiscal rules with unexpected headroom, the real challenge lies in delivering on future commitments.
By Rupert Harrison, UK Senior Advisor, and Peder Beck-Friis, Economist, at PIMCO
After months of speculation and market volatility, the UK Budget was yet another reminder that the narrative ahead of a fiscal event can differ sharply from reality. The Treasury always has far more information than anyone else about the complex moving parts driving the public finances, and what enters the public domain before Budget Day is therefore usually shaped by expectations management.
In this case, the narrative was dominated by a well-trailed 0.3-point downgrade by the independent Office for Budget Responsibility (OBR) to its assumed trend growth rate of productivity. Independent estimates of the fiscal hole against the Chancellor’s fiscal rules therefore ran as high as £40 billion, fuelling expectations of major tax rises and even potentially a breach of the Government’s manifesto commitment not to raise income tax rates.
In reality, the OBR judged that the effect of lower productivity growth on tax receipts was more than offset by the impact of higher inflation and nominal wage growth. So, while borrowing this year was revised up by £17 billion, the actual downgrade by 2029-30 (the year in which the fiscal rules are assessed) was only £6 billion, driven by overshoots in spending due to rapid rises in welfare spending, debt interest and borrowing by local authorities.
Facing a much better outlook than feared, the Chancellor managed to meet her fiscal rules with much higher headroom than expected: £22 billion compared to £10 billion at her last two fiscal events. She achieved this with £26 billion in tax rises, roughly half of which went to increasing headroom and the other half to funding welfare spending on disability benefits, pensioners and large families.
By recommitting to her fiscal rules and delivering more headroom than expected, the Chancellor did enough to trigger a relief rally in gilts on Budget Day, largely removing the additional risk premium that had been priced in after her income tax U-turn in mid-November. Markets can now re-focus on inflation, the labour market and the likelihood of renewed rate cuts from the Bank of England. Our view remains that a weakening labour market and softening inflation will lead to a deeper rate cutting cycle than markets are pricing, and the Budget has reinforced those dynamics by helping to reduce inflationary pressures into next year.
Credibility concerns
However, the credibility of the Budget is undermined by the back-loaded nature of the additional tightening. Welfare spending increases take effect early on, whilst the tax rises don’t kick in until the final two years of the forecast. As a result, the Chancellor’s decisions actually increase borrowing for the next three years, before reducing it in time to meet her fiscal rules in 2029.
In the context of the UK’s recent experience, this is starting to create a concerning pattern: for the fifth consecutive year since the pandemic, the budget deficit will be around 5% of GDP. Although the Budget forecast projects an eventual reduction to around 2%, none of this has yet been delivered.
What’s more, the Chancellor is relying on £4 billion of unspecified efficiency savings in departmental spending during the last two years of the forecast to make the numbers add up.
These years fall outside the spending review horizon, meaning individual department budgets have not been allocated. However, the OBR pointedly notes in its report that the numbers imply a significant real-terms reduction in the schools budget in 2028 and a 3.3% real-terms fall in spending outside the key protected areas of health and defence over the two years from 2028 to 2030.
The notion that a Labour Government would go into the next election with such a spending profile has raised some eyebrows to say the least. The OBR further notes that avoiding real-terms cuts in unprotected departments would require an additional £21 billion in spending, almost equal to the Chancellor’s £22 billion headroom against her fiscal rules.
Despite the immediate relief rally in gilts, the Budget has therefore heightened medium-term concerns about the Government’s ability to control spending and deliver the deficit reduction path set out in the OBR forecasts.
By increasing spending now and back-loading the tax rises and spending restraint needed to hit the fiscal rules in 2029, the Chancellor is asking markets to trust her commitment to be fiscally prudent in the future – just not yet.
Rather than relying on a five-year forecast, we believe it is increasingly important to focus on actual delivery of deficit reduction over the next two years, without further slippage – and especially proof that the UK can reach the crucial 3% level that begins to stabilise the debt-to-GDP ratio.
Investment implications
We continue to view gilts as attractive, especially the 5-year part of the curve. Despite the back-loaded nature of new fiscal measures, the UK remains on track to run the tightest fiscal policy among large developed economies next year. We expect this to reinforce pressure on the Bank of England to act as shock absorber and continue easing policy.
However, we remain cautious on long-end gilts, which are more sensitive to fiscal credibility risks, given lingering uncertainty around the near-term deficit trajectory and political developments.