Ever since the Conservative government came to power in 2010, one of its key policy goals has been reducing the annual government deficit to achieve fiscal balance. However, with the change of the Chancellor of the Exchequer in July, a change in fiscal policy could be expected.
The Autumn Statement on 23 November was Chancellor Philip Hammond’s first opportunity to “reset” fiscal policy ‒ and reset he did.
Quite correctly, the government recognized that with the deficit at 3%‒4% of GDP, the most important deficit reduction is now behind the UK, and fiscal policy no longer needs to be all about relentless austerity. This seems sensible.
The reset of policy is most evident in the projections for the deficit in the Autumn Statement compared to the forecasts in the March 2016 budget. As the graph shows, there is no aspiration to achieve fiscal balance by 2020, the date of the next general election.
More broadly, there is a recognition that even a deficit reduction to 2%‒3%, assuming growth remains at or close to current levels, will be enough to put total debt-to-GDP on a stable footing.
Given the uncertainties ahead as the UK goes through the Brexit negotiations, significant further tightening of fiscal policy probably seemed unnecessary, and this is the bet the chancellor has made.
Investors immediately responded to the Autumn Statement by selling gilts, although interestingly, the British pound was little changed against the U.S. dollar. Our sense is that UK gilts can fall further given that UK growth has already returned to pre-Brexit levels, the supply of UK government bonds is going to be higher than expected and the likelihood of further monetary easing has fallen.
However, after a sharp rise in yields already, our preference is to reflect caution on gilts relative to other high quality government bonds rather than by selling outright. All of this also suggests that the yield curve may steepen as the term premium rises on a more balanced outlook for growth and inflation.
The outlook for the British pound is a little more nuanced. The combination of a high current account deficit and more persistent fiscal deficits may well keep pressure on the pound, although that may turn out to be as much about US dollar strength as pound weakness.
Mike Amey is head of Sterling Portfolio Management at Pimco