Market Talk: UK budget could trigger 'relief bounce' | REUTERS

Key Concepts

• Fiscal Gap: The difference between government spending and revenue.
• Income Tax Bans: Thresholds for income tax rates.
• Pension Market Alterations: Changes to rules or allowances related to pensions.
• Sectoral Tax Increases: Tax hikes applied to specific industries (e.g., banks).
• Council Tax: A local government tax based on property value.
• Spending Restraint: Government measures to reduce expenditure.
• Inflation: A general increase in prices and decrease in the purchasing value of money.
• Credibility: The extent to which a budget or policy is believed to be sound and achievable.
• Issuance: The amount of new government debt (bonds) that needs to be sold.
• Kicking the Can Down the Road: Postponing difficult decisions or problems.
• Spending Spurge: A significant increase in government spending.
• Footsie (FTSE 100): The UK's 100 largest publicly traded companies.
• Footsie 250: The next 250 largest publicly traded companies in the UK.
• Rate Sensitive Parts of the Market: Financial assets that are particularly affected by changes in interest rates.
• Relief Bounce: A temporary increase in asset prices following a period of uncertainty or negative news.
• Deflation: A general decrease in prices and increase in the purchasing value of money.
• Policy Inflation: Inflation caused by government policies.
• National Insurance Costs: Contributions paid by individuals and employers towards social security.
• Energy Bills: Costs associated with electricity and gas.
• Sterling: The currency of the United Kingdom (GBP).
• Dislocation: A significant and sudden movement in market prices.
• Domestic Equities: Shares of companies primarily operating within the UK.
• House Builders/Real Estate: Sectors of the economy focused on property development and ownership.

Rachel Reeves' Budget: Market Confidence and Economic Impact

The UK markets are experiencing a significant loss of faith, with investor confidence hanging by a thread. The upcoming budget, to be unveiled by Chancellor Rachel Reeves, is seen as a critical moment to either restore clarity and steady nerves or deepen existing doubts. Months of speculation have already taken a toll, leading to stalled hiring and investors fleeing the FTSE 100 (Footsie).

Fiscal Gap and Revenue Generation

George God, a UK fund manager at Polar Capital, estimates that Rachel Reeves needs to raise approximately £30 billion to address the fiscal gap. He believes this is realistically achievable through a combination of measures:

• Freezing Income Tax Bans: Maintaining current income tax thresholds, effectively increasing tax revenue as incomes rise.
• Pension Market Alterations: Potential changes to pension allowances or rules, which could generate revenue or influence savings behavior.
• Sectoral Tax Increases: Speculation suggests potential tax hikes on specific sectors, with banks being a frequently mentioned possibility.
• Increase in Council Tax: A possibility for local government revenue generation.

God emphasizes that these revenue increases are likely to come from tax rises, with no indication of significant spending restraint from the government. He warns that raising taxes inherently has a negative impact on economic growth, highlighting the absence of "free trade" in economic policy.

Key Questions for the Bond Market

The bond markets will be quick to judge the budget, and traders will be looking for answers to four key questions:

1. Impact on Growth: Will the budget hinder or support economic expansion?
2. Inflationary Impact: Will the budget lead to an increase in inflation, similar to the previous budget?
3. Credibility: Will the budget be perceived as realistic and achievable by market participants?
4. Issuance Levels: What will be the volume of new government bonds that the market will need to absorb?

If these questions are answered satisfactorily, the bond market is expected to move on quickly. However, concerns remain about whether the budget will be an exercise in "kicking the can down the road" or lead to a "huge level of issuance" driven by a "big spending splurge." The primary concern is whether the budget will be perceived as inflationary. God concludes that while Reeves has a "relatively narrow pathway" to deliver an acceptable budget, it is achievable if these four questions are addressed.

Business Sentiment and Market Performance

CEOs have already warned of pulling back investments if the budget imposes further costs on firms. The transcript suggests that the anticipation of the budget has already had a negative impact on the domestic economy, scaring consumers and affecting smaller businesses. Businesses are looking for lower energy costs, deregulation, and lower taxes, which are unlikely to be delivered by this budget.

At a market level, there has been significant underperformance of the FTSE 250 relative to the FTSE 100, indicating that negativity is already priced in. This presents a potential opportunity for an "unwind" or a "relief bounce," particularly in rate-sensitive parts of the market, once the budget provides more clarity. The market "hates unknowns," and the budget is expected to reduce this uncertainty.

Bank of England's Perspective and Interest Rate Cuts

The Bank of England's stance is crucial. The transcript poses the question of whether the budget opens the door for a December interest rate cut. The argument is that if the budget's impact on growth is deflationary, it should accelerate Bank of England cuts.

However, the previous budget led to "policy inflation" through measures like increased energy prices, national insurance costs, and significant taxes on food and packaging, which pushed up business costs and contributed to inflation. Therefore, if this budget is not inflationary, it would strongly support a December rate cut and accelerate further cuts into the next year.

A potential policy measure that could exert downward pressure on inflation forecasts is a cut in energy bills. This could lead to accelerated rate cuts, but this is contingent on the budget's policies aligning with actions to combat inflation.

Sterling and Market Risk

Sterling traders have been hesitant to make significant directional bets, with sterling remaining relatively stable, partly due to a weaker dollar. Sterling has notably weakened against the euro in recent months amidst budget speculation.

The transcript argues that if the budget is a "total hash," the downside risk is not fully priced into sterling. Conversely, if the budget is perceived as a "trust type moment" and avoids significant market dislocation, a "relief bounce" for sterling assets, including domestic equities, house builders, and real estate, is expected. This relief bounce is contingent on the budget being acceptable to the bond market. If it is not, the expected positive market reaction will not materialize.