UK Budget 2021 debrief: reasons treasurers can feel positive about the UK outlook… for now

A more modest recovery: the UK government revised its economic outlook downward, albeit marginally, from 2021 onward.

Key takeaways:

  • Tax rises will weigh on corporates, individuals & households: most of these rate rises are back-dated (from 2023 onward) but political risks could alter the trajectory of their introduction.
  • Public debt will rise – but we don’t anticipate big jumps to medium-term borrowing costs: we think the Bank of England will step in to prevent any big spikes in yields.
  • The composition of gilts favours longs & linkers – and greens are finally on the menu: the addition of up to £15 billion in green bonds to the government’s funding toolkit could help create a sovereign green yield curve – to the benefit of corporates and investors.

Downward revisions to the economic outlook

While economic output in 2020 was better than initial estimates (see below), the Office for Budget Responsibility (OBR) now forecasts a sizeable downward revision to gross domestic product (GDP) in 2021 (4.0% from 5.5%) and a more modest-than-expected (by ourselves) rebound in 2022.

GDP forecasts – March 2021 vs. November 2020

Sources: OBR, NatWest Markets

Taking 2020 as the baseline, this profile suggests the level of GDP will be around 1.5% lower in 2021 than projected by the OBR in November 2020 and around 1.75 % lower by 2025.

Listen to the latest episode of the Weekly Watch to hear Ross Walker & John Briggs deep dive on the 2021 UK Budget’s impact on the macro outlook.

Bigger fiscal: pay now, tax later brings broad near-term business support

The March 2021 Budget unveiled a significantly larger-than-expected fiscal stimulus, with £59 billion (2.6% of GDP) of additional policy easing in the 2021-22 fiscal year to support the economy through (what is hopefully) the pandemic endgame: an extension of the furlough scheme (£6.9 billion), income support for the self-employed (£12.8 billion), business grants (£5.0 billion), 3-month Business Rates holiday (£6.8 billion), VAT cut extension for hospitality sector (£4.7 billion) and a 6-month Universal Credit extension (£2.2 billion).

With most of these measures extended to September and the government’s goal of removing most pandemic-related restrictions by June, many businesses may take solace in additional near-term support. Measures like the temporary 'super-deduction' of up to 130% made available to encourage investment in new plant & machinery may also help get domestic manufacturers spending.

No such thing as a free lunch: taxes will rise, and remain a risk

As anticipated in our Budget preview, the UK fiscal policy stance remains one of significant, if diminishing, accommodation. But larger-than-anticipated fiscal support in the near term will come at some cost: higher taxes. Although most of these back-loaded tax increases (2023 and beyond) fall on the corporate sector, a sizeable proportion will hit household, mainly through freezes to thresholds and allowances.

The fiscal deficit is projected to balloon to £234 billion (10.3% of GDP) – much larger than the £164 billion (7.4% of GDP) outlined in the OBR’s previous forecast in November 2020, and the projected deficit reduction continues to reflect a combination of broadly stable tax receipts (as a % of GDP) and significantly reduced public spending (see chart below).

UK tax receipts & government spending (% of GDP)

Sources: OBR, Office for National Statistics (ONS)

Whilst in principle, returning public expenditure levels to pre-crisis norms over time should be perfectly feasible, downside risks aren’t to be sniffed at. The general election scheduled for 2024 will make it more politically challenging to deliver new tax revenues. Brexit-related risks – some obvious, like lower income tax and stamp duty receipts from the financial sectors, and others less so, like potential structural change in output & trade within a new UK-EU paradigm – will need to be closely watched.

Public borrowing, interest rates, and quantitative easing: a delicate interplay unlikely to lead to higher medium-term borrowing costs

More-than-expected stimulus will of course lead to changes in the government’s borrowing. UK public sector net borrowing (PSNB) during the 2020-21 fiscal year is, as expected, on course to under-shoot the OBR’s November 2020 forecasts. So too is the Central Government Net Cash Requirement (CGNCR, which forms the basis of gilt issuance) – see the chart below for borrowing & debt forecasts.

Borrowing & debt forecasts

Sources: NatWest Markets, OBR. PSNB-ex is public sector net borrowing excluding loan loss provisions.

But the borrowing profile in subsequent years is more variable than we (and seemingly the market) had expected: an enormous increase in borrowing in the 2021-22 fiscal year, with PSNB revised up by a staggering £70 billion, to £234 billion (from £164 billion), followed by a more rapid reduction in projected deficits as tax rises take effect.

Rising longer-dated gilt yields combined with the prospect of far more near-term public sector borrowing have led to concerns around rising borrowing costs over the medium-term – for both the UK government and corporates. Indeed, the recent rise in 10-year and 30-year bond yields serves as a reminder of the heightened sensitivity of the government’s debt-servicing costs to higher interest rates. The OBR estimates that a 1% rise in short and long-term interest rates would increase the government’s debt interest spending costs by £20.8 billion (0.8% of GDP) in 2025-26. To put that figure in context, it is roughly equivalent to two-thirds of the projected medium-term fiscal tightening.

Putting to one side any market concerns over increased borrowing materialising more quickly than (largely back-dated) tax revenues, we think the substantial increase in gilt supply will increase pressure on the Bank of England (BoE) to provide some response to the upward march of yields – and therefore we don’t think it’s likely we’ll see significantly higher borrowing costs any time soon.

The composition of gilt issuance favours longs & linkers – and greens are on the menu

The new headline issuance number of £295.9bn is clearly high (an upside surprise for most), and as we suspected in our preview, the proportion of short and medium-term gilts was reduced while favouring more long-term and inflation-linked notes (albeit in slightly different measures than we anticipated).

Historical composition of gilt issuance

Sources: NatWest Markets, UK Debt Management Office (DMO)

Green gilts, up to £15 billion worth, are now firmly on the menu. Sovereign green bonds would no doubt reinforce the UK’s position as a leader in sustainable finance ahead of hosting the COP26 meeting in Glasgow later this year, and on a more practical level help create a liquid sovereign green yield curve – an important pricing benchmark for corporates & investors active in sustainable finance markets.

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