Jupiter's Hamilton: Osborne will carry on regardless

Jupiter Corporate Bond manager John Hamilton (pictured) gives his take on this week's Budget, and assesses the prospects for the asset class.

This week, despite higher inflation and slower growth, chancellor George Osborne confirmed that he would stick to his guns and carry on reducing the deficit. The 2011 Budget therefore did not deviate from the aim of tackling the deficit within the life of one Parliament and did not upset the gilt market where any slippage would have caused alarm.

Instead, it was very much business as we saw it last June when the emergency Budget of fiscal tightening (supported by a fingers-crossed policy of ultra-low interest rates) was introduced to stave off a sovereign debt crisis similar to that experienced by Greece, Ireland and soon possibly Portugal. Faced with two unpleasant alternatives, the coalition government decided it was better to risk growth faltering than to allow an escalating debt crisis.

So, whereas the US chose to stimulate its way out of recession, the UK embarked upon one of the most significant budgetary tightenings of any developed economy. This begins next month and will run for four years.

The June 2010 emergency Budget was deemed credible by the gilt market as the yield on ten-year gilts stabilised at around 3.5%. Nine months later, the budget deficit might be a little lower than estimated but the economy has been growing more slowly too. So there has been no major change in the ratio of debt to GDP and, thus, not much room for manoeuvre.

However, by confirming that he aims to contain the deficit with a year to spare, the Chancellor has retained a small amount of wriggle room should growth falter, which it might well do. 

All Budgets rely on growth forecasts but the newly created Office for Budget Responsibility is arguably no better (or worse) than any other independent forecaster. However, it does prevent future Chancellors from tinkering with their own growth estimates by bending Golden Rules, adding extra years to “the cycle” and so on.

Compared to nine months ago the OBR has lowered its near-term estimates for economic growth but maintained an expectation of a strong recovery. These are as follows:

Although the Budget was fiscally-neutral (all the bad news having been already announced) the economy has strayed off course somewhat. Thus there was a slight worsening in the borrowing position and the government now needs to borrow an additional £46bn over the next five years according to the OBR projections. This means that the debt to GDP ratio is now likely to peak at 71% in 2013/14 compared to the 70% predicted in November. Markets, however, took this in their stride as the longer-term picture, i.e. of the debt burden gradually declining thereafter, remained intact.

But if the economy were to suffer a further year of weak growth, then the government would need to demonstrate that it had an alternative plan. Any such plan would be unlikely to involve fiscal stimulation, for fear of leading markets to doubt its main strategy, so the onus would largely fall upon monetary policy.

Perhaps it was with this in mind that the Chancellor announced the intention to build up the UK’s foreign currency reserves. Higher foreign reserves would provide a greater ability to ensure sterling remained competitively priced if any intervention later became necessary.

The raft of micro-measures in this fiscally-neutral Budget is designed to reinforce the message that Britain is open for business. This is all well and good. But raising productivity, and thus the structural rate of economic growth, remains a slow and protracted task.

The yield on ten-year gilts barely reacted to the OBR’s lower growth forecast as the big recent news was another large jump in inflation. CPI for February was 4.4%. And, with RPI inflation at 5.5%, the highest since July 1991, real interest rates remain extraordinarily stimulatory at -5%. However, this economic “fuel” is unable to get from the pump to the tank as bank lending remains constrained by the need to bolster their weakened balance sheets. Meanwhile, consumers continue to see their real incomes squeezed tightly.

Until recently, the gilt market had been anticipating, perhaps wrongly, an almost immediate increase in the Bank base rate to counter the deterioration in inflation expectations created by higher food and fuel prices and VAT. Since then, the uprising in Libya has pushed oil prices higher. This is likely to dampen growth further while increasing inflation. Japan accounts for around 9% of global growth and the earthquake there will have some knock-on effects for the global economy as will China’s continued moves to contain the rate of its economic expansion.

In addition, in the United States, QE2 comes to an end in three months’ time. It remains to be seen whether the monetary plaster is being ripped away before the underlying wound is properly healed.

With the British economy remaining vulnerable to the health of its overseas trading partners and mindful that the current externally-induced burst of inflation might begin to subside, the Bank of England is likely to “ease off the accelerator” cautiously. It will not fully normalise interest rates until certain that recovery is on a firm footing and the worst of the coming fiscal retrenchment is over. Meanwhile, good quality corporate bonds should prove a relatively safe source of long-term income for investors at a time when other sources have diminished.