DIGIT Digest: Unpacking the Budget – what does it really mean for UK growth?

Listen to the latest episode of our podcast series, DIGIT Digest. In this episode, Ben Ritchie and Rebecca Maclean, Co-managers of Dunedin Income Growth Investment Trust, are joined by Luke Bartholomew, abrdn Deputy Chief Economist. Following the highly anticipated UK budget, Ben, Rebecca and Luke discuss the budget itself, its impact on the UK economy and markets, and ultimately, what they think it means for companies.

Transcript

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Podcast from abrdn Investment Trusts.

00:00:09:15 - 00:00:37:00

Hello and welcome to DIGIT Digest. My name is Ben Ritchie, one of the co-managers of Dunedin Income Growth. And I'm delighted today to be joined by Rebecca McLean, my co-manager. And also Luke Bartholomew, deputy chief economist here at abrdn. And today we're going to be talking about the UK budget that we had last week. Its impact on the UK economy, impact on markets and ultimately what we think that means for companies.

00:00:37:02 - 00:01:13:20

So, Rebecca, your sort of headline thoughts on what we heard about last week. Yeah, it was a much anticipated budget, sort of you know 100 days after the government was elected. The market was watching closely. I think it was high hopes, for the budget and indeed, the initial market reaction was positive during the speech. However, as the markets start to digest some of the forecasts around the office, the budget responsibilities, outlook for GDP and inflation, we did see some nervousness in the markets, particularly around inflation.

00:01:14:01 - 00:01:37:22

And so there was a shift in sentiment. And this led to an increase in borrowing costs for the government, which did ripple through to equities. Now we've seen equities recover. And even the more domestically focused Footsie 250 is broadly flat. It's down about 1.5%. And as of today which is the 4th of November on budget day.

00:01:37:24 - 00:02:19:12

But certainly there was a shift in sentiment. And the market has been digesting the details of the project. Thanks, Rebecca. So messaging was, as we look at the details, less positive and enthusiastic than we were before we looked at the details. I think there was, a degree of positive goodwill, I think, for markets towards the Chancellor and the government and certainly looking for investment, supportive of that, supportive of infrastructure, supportive of a long term plan, I think, though always a little nervous about exactly how all that was going to be paid for and what the implications might be medium to long term.

00:02:19:14 - 00:02:48:07

Look, it would be fantastic to get your thoughts, from a high initial level, on the budget. Sure. So, I mean, the first thing to say is, from a macroeconomic perspective, this does represent quite a significant increase in taxation, spending and investment, which on balance leads to quite a large fiscal loosening over the next couple of years, which should push up on growth a little bit.

00:02:48:13 - 00:03:14:10

But over the medium term, it's less obvious that this kind of fiscal stimulus leads to a lasting increase in growth. And indeed, that's what's reflected in the OBR forecast. And the reason for that is that ultimately, the UK economy is pretty close to full employment. At this point. There aren't that many, unused resources that could just be put to work, as a consequence of the fiscal stimulus.

00:03:14:10 - 00:03:40:03

Instead, really, what's happening is a redistribution. It's an increase in the size of the state. There's a crowding out effect, and that has to be mediated through interest rates. And so interest rates are probably likely to fall a little bit less rapidly than they would have done previously. And perhaps that explains some of the gilt market reaction that you guys were describing.

00:03:40:05 - 00:04:18:09

But then looking to the long term, there is the hope that this increase in investment should help to boost the productive capacity of the economy. And that's really where the action comes from in terms of growth boosting. It's less about fiscal stimulus and more about what it does to the productive capacity of the economy. I mean, the one thing that sort of surprised me, I had the maybe the miss pleasure to have to persuade my ten year old driving in the car down from Norfolk during half term to put the budget on the radio, that aside from the slightly unpleasant sort of behavior of MPs, which I always find quite remarkable and always comes

00:04:18:09 - 00:04:44:20

across particularly, annoying when you listen to it without being able see them as braying at every opportunity, was as Rachel, as she took the time to spell out each and every year in terms of GDP growth and then inflation rates and and not being an economist. But I was quite surprised that they were forecasting inflation above the Bank of England's target all the way out to 2029, effectively beyond the scope of this Parliament.

00:04:44:22 - 00:05:11:08

Do you think that's quite significant that to some extent the government is stepping away from the inflation target, or at least, I guess putting together a set of fiscal policies that produce a forecast that's outside of that range. So I think it's perfectly reasonable for the OBR to be forecasting inflation above target for the next couple of years or so.

00:05:11:08 - 00:05:33:18

I mean, we are talking relatively modestly. Above 2% is worth saying, given the journey of inflation that we've been on over the last few years, 2.5% or so probably feels like a relatively mild overshoot. But it's a it's an overshoot nonetheless. And I think that makes sense in the context of this fiscal stimulus in to, as I say, an already full employment economy.

00:05:33:18 - 00:06:03:14

So you're just adding demand. And that tends to be somewhat inflationary at the margin. And there's also a relatively large increase in the national living wage, the minimum wage as well. And at least some people will have a concern, I think, that has the possibility of causing increases, not just at that point in the wage distribution, but also other points as well as workers and employers work to try and keep the existing wage differentials the same.

00:06:03:16 - 00:06:30:15

But I think over the medium term, I would probably be, a little bit less open to the idea of inflation persistently being above target. I mean, ultimately, it's it's the job of the Bank of England to set monetary policy such that inflation is met. And so if we are persistently away from 2% over the next five years or so, that feels to me more like a policy error from the Bank of England rather than the government.

00:06:30:15 - 00:06:49:01

The Bank of England knows the government's plans and it should be able to set monetary policy accordingly. And yeah, there are variable lags. There are difficulties in fine tuning, but over that kind of horizon it does feel that it is very much within the power of the Bank of England to be able to set monetary policy, according me.

00:06:49:02 - 00:07:10:13

So yeah, open to the idea that inflation could be a bit higher for the next couple of years. But if it if it's much higher after that, I wouldn't want to say that's the government's fault so much as it is whether the Bank of England set policy appropriately or not. But then, do you think that we'll be looking to revise our own expectations of the sort of pace and path of Bank of England rate cuts?

00:07:10:15 - 00:07:44:07

So we were all already a little bit less excited about the market than the pace of rate cuts in the near term. Partly because we were expecting some fiscal easing from the government, maybe a little bit less than this. But still, the fact that the UK had growth, that, you know, compared to the rest of Europe, that relatively solid unemployment that's still falling, you know, it felt to us that, there were good reasons for thinking the Bank of England might be a little bit slower.

00:07:44:10 - 00:08:06:17

So yes, the market has repriced quite a lot, but I feel that that was probably coming from a position where, already there was perhaps too much priced in. But certainly, you know, it is reasonable to think that, again, fiscal easing into this kind of economy will cause the Bank of England to cut rates quite as rapidly.

00:08:06:17 - 00:08:26:14

But for us, that was sort of already baked in. So for what it's worth, we're expecting a cut this week as we speak on Thursday, that looks basically nailed on. And then we expect the pace to remain quarterly through much of next year. So sort of cutting one meeting there, missing one meeting and then cutting the next.

00:08:26:14 - 00:08:52:16

And that's by contrast to say, the fed in the US or the European Central Bank, where maybe there's a bit more of a consecutive go after every meeting pay. So, you know, a bit slower, but still, you know, enough to, over the course of the year, take interest rates down a decent amount. In terms of inflation, I mean when we sort of think about price shocks in the past, what do you think about the direction of prices for UK corporates?

00:08:52:16 - 00:09:17:00

Do you think that the reflex is going to be to look to recoup margin through putting prices up, but you think competition is going to offset that regulation perhaps. And how do you think companies are going to sort of set out to tackle the impact on profitability from, from the increases in both the national living wage and also the increase in National Insurance.

00:09:17:02 - 00:09:45:10

So my my best guess is that the final incidence of the increase in employers National Insurance will largely fall on workers and consumers in the form of lower wages than they otherwise would have been, lower hours worked and higher prices. I mean, there might be some squeeze on margins, but I suspect most of it will end up being passed through.

00:09:45:12 - 00:10:10:03

I think what is interesting is, as you point out, the interaction with that increase in National Insurance with also at the same time, an increase in the national living wage as well. And those two together do constitute quite a large increase in the cost of employing low wage people, certainly as a percentage of the total cost then.

00:10:10:05 - 00:10:29:24

And it is worth saying that maybe there's been a sense of crying wolf, or at least some people might feel it that way around increasing the minimum wage before that. It hasn't previously led to, you know, a material increase in unemployment in that sector. That's the kind of thing that you might have feared. But the worry is that maybe there is a tipping point around that.

00:10:29:24 - 00:11:00:00

And particularly as it comes to interact with the increase in National Insurance as well, that you could see quite a strong incentive to reduce employment at that part of the wage distribution. Maybe that's through automation, investing in capital automation technology of one form or another, where that's appropriate. And perhaps in other cases it may just be as simple as as reducing employment and reducing output accordingly.

00:11:00:00 - 00:11:23:16

But that's where I see that being a bit of difficulty in digesting this, maybe. But yeah, broadly speaking, I think it's it's unlikely to be a huge margin squeeze, at least from the increase in taxation. And if we maybe sort of think about the other side of the coin from a quote perspective, increased spending, I guess it was a result of higher levels of GDP.

00:11:23:18 - 00:11:50:05

But how do you sort of see that working further forward? And do you think ultimately that the government will be able to get that productivity driven, economic expansion to come through? So I really hope so. The government's target that it's set for itself is 2.5% growth. And I think it's pretty clear that this budget doesn't get you there, but then it never really was.

00:11:50:05 - 00:12:21:19

The way to get to 2.5% growth is free supply side measures. It's through changes to the planning system, to the competition environment, perhaps through the industrial strategy, ways of dealing with energy prices, perhaps in trading relationship with Europe as well. But really on that planning side, I think is where the juice is going to be richest if that isn't mixing metaphors.

00:12:21:21 - 00:12:53:14

So it really is just a case of waiting to see whether that's delivered. I'm hopeful they've made the right noises. But yeah, this budget isn't going to do that. But maybe it's, you know, maybe there are some small steps in the right direction investing in some aspects of long term productivity growth. But, yeah, we haven't revised up our long term forecasts yet, but hope to have to do so as and when those planning reforms start to get announced.

00:12:53:16 - 00:13:14:18

Rebecca, maybe we could turn to the markets and think about the sort of sectors in the UK that might be winners and losers as a result. Yeah, I think going into the budget, there was some concern about particular sectors that may be targeted by the government, which turned out to sort of not have the same impact.

00:13:14:18 - 00:13:37:20

So, for example, there was concern around maybe the banking sector and an additional tax there, also gaming too and so those sectors did avoid that. And instead, the budget was much more broad in terms of its reach of companies, in terms of I suppose that tax side. Whereas on the positive side, again, sort of I wouldn’t say there were any particularly big winners.

00:13:37:22 - 00:14:05:14

I think we need to hear that detail in terms of the policy, as Luke mentioned, really, to understand what it means on an individual sector basis. But there were a couple of sectors that I'd pick out where there were some incremental positives. So for example, construction sector, as I say, no big surprises, but the sector should benefit from more spend in infrastructure, you know, whether that's roads or hospitals, or prisons.

00:14:05:16 - 00:14:29:01

And so we've got a number of names in the trust which do operate in UK infrastructure. So for example, Genuit, which has got a water management system. So that will benefit when there's investment which required sort of stormwater investments or wastewater. So you know thinking about road infrastructure for example. The company's got a number of solutions in that area, but also in their sustainable business solutions too.

00:14:29:01 - 00:14:59:08

So sort of incrementally positive for a company like Genuit, also Morgan Sindall, which currently has a number of customers on the infrastructure side. So for example, they are involved with National Grid in investing in the grid infrastructure in the UK, as a construction partner. So again, I think incremental positives there in terms of that commitment to invest in upgrade UK infrastructure.

00:14:59:10 - 00:15:25:02

And then another sector I'd highlight would be home building. I think there was an expectation maybe there'd be more support. So not going as far as a help to buy, for example, for first time buyers, but maybe more support there. And instead the policies that were announced were helpful, but not particularly meaningful in terms of there was some incremental spend, for affordable housing, which should be helpful.

00:15:25:04 - 00:15:46:04

And also the government has talked about easing the planning system. So more resources, for example, helping to deal with the planning bottleneck that there is, which is helpful, and actually from our discussions with some of the housebuilders in the last couple of weeks, we are hearing they're already seeing some of that easing in the pipeline for planning.

00:15:46:04 - 00:16:11:12

So that's certainly helpful for the housebuilders. So for example, we own Taylor Wimpey in the trust, which is a large volume housebuilder which has experienced, you know, very material decline in the volumes to houses completed in the UK along with the rest of the sector. And there's an expectation that there will be a recovery. And part of that will be due to some of those supply side initiatives to help with planning reform.

00:16:11:12 - 00:16:36:13

So I think some helpful, for the housebuilding sector. And then maybe the last one would be support for electric utilities and a commitment to the Department of Energy and Security and net zero, carbon capture storage was called out. So was green hydrogen projects. You know these are much more long term projects, and we do need to hear the detail to understand, what it means in practice, but certainly sort of helpful for those long term themes.

00:16:36:15 - 00:17:20:00

You know, in the trust we've got SSC and National Grid, which are benefiting from what we're seeing as an uptick in investment and growth. In the electricity network and transmission sector in the UK. So those are probably three sectors where there was, modest support from the budget. And in terms of your conversations with companies, I appreciate it’s only been a few days, but are companies starting to process some of the details that have been coming through, are you getting any indications from them in terms of, you know, cost impact and potential mitigations. Bring it back to the point about the cost for businesses and where we're looking at which of those companies which

00:17:20:00 - 00:17:47:07

have got high employee costs already, which are going to be now facing an increased national living wage, and also this employer National Insurance contribution. So when we think about what sectors will be most impacted by that in the UK it's probably the retailers but also the leisure sector. So we are yet to hear from the companies about how they're going to manage that cost, to what extent they're able to offset with efficiency gains, or whether they will be passing that cost on to the consumer.

00:17:47:09 - 00:18:05:19

We're yet to hear. But then on the other side, some of these companies will benefit because their consumers are those individuals who are benefiting from their wage increases, you know, whether they're public sector employees or their on national living wage or the tiers just above that, which should benefit from an increase in national living wage. So there are some sort of puts and takes here.

00:18:05:19 - 00:18:32:11

It's kind of hard to draw very and some conclusions, but it's certainly sort of on a near term, probably going to limit some of the upgrade potential in some of these sectors as they absorb and sort of work out how they're going to manage some of these costs. But ultimately, I think then also comes this question about driving productivity and to what extent companies are able to use technology and efficiencies to be able to improve the efficiency of their businesses.

00:18:32:13 - 00:18:53:01

And what's your sense, in terms of the UK's positioning, sort of vis-a-vis other European markets, other global markets? And what does this do for external investment into UK equities? And do you I guess we've been through a brief honeymoon period where some of the uncertainties around the election at past, there are obviously concerns about what might happen in the US.

00:18:53:01 - 00:19:17:09

France is having issues. Germany's got well-documented challenges and the UK was looking, like a little relative beacon of global stability from an economic perspective. What do you think the budget does for attracting inflows into UK equities? Taking a step back, I think, as you say, the UK economy is gradually recovering from a shallow recession last year.

00:19:17:09 - 00:19:42:21

And we are seeing that pickup in growth. And, you know, as I've spoken about, the budget does speak to higher GDP growth in the UK, particularly in the near term, there's this question mark over the long term, but that has to be helpful in terms of sentiment towards UK and equities, because if you're getting positive revisions in GDP for the portion of the market which is linked to the UK, then that should be helpful.

00:19:43:02 - 00:20:01:20

And I think, you know, the other point would be just removing uncertainty here. Now we've got the budget. And this is something that the market was looking for as a clearing event. And whilst there has been some nervousness about the debt and sort of the cost of borrowing for government, it does remove that uncertainty in terms of setting out what the priorities are for the government.

00:20:01:20 - 00:20:31:03

And yes, we do need to have greater visibility on the legislative agenda, and the details of the policy, but at least we know where the main buckets are for the government to target, and removing some of those overhangs, as I mentioned, some of those sectors which were feared they could be targeted. So I think that's also helpful to just to remove that uncertainty so that we can actually focus on the health of the economy, which is, as I say, sort of picking up, maybe the strength of the consumer as well, which may be benefiting from wage increases.

00:20:31:05 - 00:20:54:03

And meanwhile, UK equities market is trading at about 12 times pe, is trading below its median long term average multiple. And if you compare this to other markets which are trading at or above historic levels, then I think on a relative basis the UK looks well-placed for future prospective returns. And Luke let me turn to you as well.

00:20:54:04 - 00:21:16:22

Have you got some thoughts on where this budget stands in a sort of historical context, looking back at other sort of big broking budgets that have shifted away from the from the previous consensus of sort of economic approach, it'd be interesting to get your thoughts on where you see this standing in that list? And I guess some sort of ideas as to how some of those budgets went over time.

00:21:16:24 - 00:21:42:17

Sure, yeah. Well, look, I mean, the, the obvious budget comparison that the government was trying to avoid was the 2022 mini budget debacle right. And I think there might have been a slightly scary moment back on Thursday, Friday when gilt yields were rising and the pound was selling off, when some of those worries, looked like they might be coming back.

00:21:42:17 - 00:22:08:15

But thankfully we seem to be through that. And that feels right to me. I don't think what the government has done this time feels quite as quote unquote radical as, as the mini budget and the markets reaction. Therefore probably, you know, it is appropriate that it is rather smaller than that. I mean, what's interesting about this budget, I suppose, is that simultaneously quite a large tax increase, but also a lot of frontloaded fiscal stimulus as well.

00:22:08:15 - 00:22:38:02

And it's unusual to get both those things happening at the same time. I mean, I guess one budget that in a weird way, has some similarities with is the 2010 first George Osborne budget. And the reason I say that is just because of what it does around fiscal rules. Of course, it was the Osborne budget that introduced the the OBR enshrined that, as a key part of the fiscal architecture of the UK.

00:22:38:02 - 00:23:14:04

And in some senses, this budget is is an evolution of that, both in terms of really entrenching the OBR, but also the shifts around investment rules and making it easier to invest in the future, a perhaps a natural evolution of that fiscal framework and in some ways probably an improvement as well. I mean, one, one budget that is often talked of as being the most radically transformative in at least modern economic history in the UK is the 88 Lawson budget, which was a big tax reforming budget.

00:23:14:04 - 00:23:51:18

And that's what this budget certainly isn't. There's no sense of like tax reform. Obviously it changes the amount of taxation. But in terms of going after the tax code and trying to radically shift, the sources of revenue raising and perhaps the incentives that are embedded, that's that's not what this budget is, but, you know, arguably the the Lawson budget didn't have a particularly happy afterlife, at least in the short to medium term, often thought of as creating a bit of a short term artificial boom, the that may be in some senses powered what ended up becoming Black Wednesday and the UK falling out of sterling in it.

00:23:51:18 - 00:24:09:17

I'll give you the the history of that event starts with that budget. So, you know, the fact that this one isn't radically tax reforming like 1988 maybe isn't such a bad thing in that sense. And then finally, you know, often what people say about this budget is that it's the the biggest tax increase in budget in 30 years.

00:24:09:17 - 00:24:39:21

And that's right. And the previous budget that did have significant tax increases was the 1993 Lamont budget clearing up from the mess of Black Wednesday. And despite, because of, depending how you want to to frame this those tax increases the next well ten years or so, ten, 12 years or so, but in political terms, the next 4 or 5 years or so represented a very strong period of of economic growth in the UK.

00:24:39:21 - 00:25:05:04

So I think perhaps that's the budget that Rachel Reeves will hope this one, to an extent, feels like, historically speaking. Tax increases that lay down fiscal stability, that provides the foundation for for stronger growth over the next few years. Thanks Luke for that. That's a great context to put today into. If we sort of step forward a year, I mean, what do you think the priorities will be of the of the next budget?

00:25:05:05 - 00:25:41:24

I know that sort of maybe seems a little way away from here, but having set out there, I guess that sort of offering, what do you think the focus will be from the government as they move through into 2025? So the Chancellor's hope in the next budget, I think, is that it will be a bit of a nonevent that the hope is that they've done most of what they need to do in terms of tax increasing, changing the fiscal rules, and then they can allow the supply side agenda, the planning agenda, the industrial strategy agenda to be rolled out over the next year or so.

00:25:41:24 - 00:26:10:16

I mean, the the big concern for the government, though, would be that that there isn't a huge amount of space on the current fiscal plans against the new fiscal rules. There is quite a real risk of fiscal slippage, if gilt yields end up being, you know, persistently higher than they have been recently, or if growth comes in worse than expected, or there are just demands on spending that turn out to be higher.

00:26:10:16 - 00:26:30:15

If that's the case, then the Chancellor may find that she has to come back asking taxpayers for more tax increases and the gilt market for more borrowing. But as I say, the hope, I think, is that the budget will be will be somewhat less eventful, and it will be other parts of the agenda that does the talking from here.

00:26:30:17 - 00:26:54:13

And maybe, Rebecca, a final thought from you on how we might see equity markets absorbing this and where the opportunities might be from here. So I think the, you know, the budget is helpful, in order to see what the sort of high level agenda is this government. But we do need to wait for the legislative measures to be put in place in order to assess success.

00:26:54:15 - 00:27:14:22

But at its core, you know, this is a budget for growth. And if it does stimulate economic growth through spending, but also investment, that should be helpful for companies who are operating in the UK. And then a relative basis, the UK is recovering. And maybe we're getting upgrades to that economic outlook for the UK economy.

00:27:14:22 - 00:27:33:00

So I think on a relative basis the UK looks well placed too. So, I think it's helpful to have this as a clearing event and will look towards the detail from a policy perspective, but also speaking to companies that we own in the trust over looking at investing in about how they're responding to this budget and what it means for them.

00:27:33:00 - 00:28:00:07

And we'll see that into our portfolio construction. Well, thanks very much for that, Rebecca. Thank you. If you would like to find out more about Dunedin Income Growth, then you can go to www.abrdn.com/dig 

00:28:00:09 - 00:28:27:08

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