Next Week's U.K. Budget Could Jolt the Pound and Bonds

 | Mar 03, 2017 | 8:00 AM EST
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Next Wednesday, all eyes will be on U.K. Chancellor of the Exchequer Philip Hammond, who will present the country's budget. But investors should not hope for massive fiscal stimulus. On the contrary, austerity is likely to continue, perhaps in a different form. And even so, the British pound and U.K. bond prices might suffer.

Immediately after last June's Brexit vote, the British economy defied predictions of gloom and advanced strongly. However, a deeper look at the figures shows that consumption played a disproportionately large part in that advance; it is not clear that consumers will spend at the same pace going forward.

Data from the Office for National Statistics show the wholesale retail sector made up more than 11% of total GDP in the fourth quarter of last year and jumped by 3.4% from the third quarter. Of course, some seasonality could be in play, as the fourth quarter is when winter holidays fall. But in the same period of 2015, the sector's advance was just 0.5%; in 2014 it was 1.6%, and in 2013 it was 1.2%.

There are two possible explanations for the big jump in consumption late last year: either consumers were so giddy at the thought of leaving the European Union that they flashed the cash, or they were stocking up ahead of an expected rise in inflation. The pound tanked by around 18% vs. the U.S. dollar following the June vote, and Britain imports a lot of consumer goods.

The second explanation looks more likely in the light of recent data from the Bank of England, which show that for the first time since 2012 growth in consumer borrowing slowed for two months in a row.

Other signs of prudence come from businesses, even before the actual beginning of the Brexit process, which Prime Minister Theresa May has said will take place by the end of this month.

Staffing group Adecco reported a 15% fall in its permanent placement business in the U.K. in the fourth quarter, much deeper than the third quarter's 5% fall. The decline was driven by a decrease in hiring in financial services in London, as banks and other financial sector firms consider moving part of their operations to EU cities in order to maintain their right to sell services in the other 27 member states.

A survey by the U.K.'s biggest lender, Lloyds Banking Group, showed small companies reined in their investment plans for the first half of this year because of prolonged uncertainty. Companies with turnover below £1.0 million ($1.23 million) now expect to invest 74% less in the first six months of this year than they did when surveyed in July last year.

The most commonly identified threat over the next six months is economic uncertainty, with 31% of businesses citing it, followed by 17% that mentioned weaker demand in the U.K. and 10% that said political uncertainty.

Various sectors of the economy already have called for guarantees from the government that they will not be worse off after the U.K. leaves the European Union. Perhaps most tellingly, the latest of such requests comes from the consumer sector itself.

Ahead of next week's budget, commercial insurer NFU Mutual called for a cut in the value-added tax (VAT) from its current level of 20% on most goods and services.

"As business rates, Brexit and rising inflation continue to put immense financial pressure on businesses, the Chancellor has the opportunity to ease some of those concerns at the Spring Budget," Frank Woods, retail sector specialist at NFU Mutual, said in a statement. "A cut of VAT by just 5% could encourage consumer spending in retail with anywhere up to £11.2 billion and tourism with up to £10.3 billion."

It is unlikely Chancellor Hammond will be ready to part with 5% of the £120.1 billion the VAT is expected to raise in 2016-2017. After income tax and national insurance, this consumption tax is the third most-important source of revenue to the U.K. budget, making up 16.8% of total receipts, according to research by the Institute for Fiscal Studies.

It is equally unlikely that he can afford to stimulate domestic consumption at a time when the exchequer needs all the revenues it can get in order to offer welfare aid should workers find it difficult to find jobs as companies pull back on investment plans with the beginning of the EU withdrawal process.

The most likely scenario is one where the budget deficit remains large or even increases a little, despite recent data showing that it would undershoot predictions for this year. That's because the Chancellor will have to accommodate potential additional demand for government money, while austerity in the form of spending cuts in areas such as housing benefits continues. If that is the case, U.K. government bonds and the British pound are probably not good investment ideas right now.

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