The national debt is huge and growing, and real incomes are squeezed by tax and inflation. But it’s not all doom and gloom, says David Stevenson.
Despite the heavy-duty austerity package the coalition brought in to try to rebalance Britain’s books, our national debt (what the country owes in total) is still rising far too rapidly for comfort. The fact is that the government is still spending much more money than it’s collecting in taxes – this annual overspend is what the government is referring to when it says it wants to cut the deficit.
Slower growth, rising debt
This point is worth bearing in mind. Over the next few years, government spending cuts, severe as they may be, will merely slow the rate at which we’re overspending – they won’t actually make a dent in our overall debt. If any reminder was needed about how tough a task the coalition still faces on dealing with this revenue shortfall, the latest monthly borrowing figures – published the day before Osborne presented the Budget – provided it.
As Jonathan Loynes of Capital Economics put it, February’s public finances “presented a distinctly unfavourable Budget backdrop. The ÂŁ11.8bn monthly public borrowing total was way above the consensus forecast of ÂŁ7bn-odd.”
For the financial year that ended on 5 April 2011, the Office of Budget Responsibility (OBR, Britain’s new independent financial watchdog) now expects UK public-sector net borrowing to hit ÂŁ146bn. While this is a tad lower than the previous forecast, it still takes our national debt to around ÂŁ1trn. That’s the equivalent of about two-thirds of Britain’s entire annual output.
It’s by no means the world’s worst, but it’s not pretty either. It’s a further reason Osborne wasn’t able to hand out more Budget ‘giveaways’.
Then there are more disturbing disclosures. Amid the small print, the Budget quietly slipped in a forecast that Britain’s debt mountain will grow faster than had been hoped over the next five years. That could yet be a serious issue, and later in this article we will examine what it means over the longer term. But it also ties in with another bit of bad news. Officially, economic growth is now expected to come in lower than was hoped – the OBR has cut its forecast for UK GDP growth in 2011 from 2.1% to 1.7%. For next year, the prediction has been trimmed to 2.5% from the earlier 2.6%.
This is important because the pace of economic expansion is a major driver of tax revenues. In other words, slower GDP growth means the UK’s overall tax-take is likely to fall. In fact, the real risk must be that Britain’s economy does even worse than the downgraded forecasts from the OBR, while the next few years see hardly any pick up.
Where is the main potential damage to the economy likely to come from? This week we saw the third and final estimate of British GDP for 2010’s fourth quarter. At first glance this seems no big deal. The quarter-on-quarter change was revised from a drop of 0.6%, back to the initial 0.5% fall. But as Chris Crowe of Barclays Capital points out, the devil is in the detail. “The major news lies in the downward revision to consumption growth,” he says, “where momentum at the end of last year was clearly more negative than previously thought.” In short, people weren’t spending as much as had been expected.
And now we know why. The latest Office of National Statistics figures confirm what everyone’s petrol, heating and food bills have been telling them for a while. In real terms – ie, after allowing for inflation – UK disposable incomes fell in 2010’s last quarter for the first time in almost 30 years. In other words, the cost of meeting our expenses is rising faster than our earnings. There’s no real sign of improvement on the horizon. The full impact of hiking VAT from 17.5% to 20% has still to be felt, while both income tax rises and higher national insurance contributions will start to bite this month.
“Consumers are being squeezed and we’re likely to see another decline in real incomes this year,” says Andrew Goodwin, senior economic adviser to the Ernst & Young ITEM club. “If that happens, it would be the first back-to-back decline since the mid-1970s.”
That would be bad news for the economy, says Scott Corfe at the Centre for Economics and Business Research. “With household consumption accounting for about 60% of GDP, this is a major downside risk to growth in 2011.”
The stealthiest tax of all
There’s another key factor putting the squeeze on us all, apart from those tax increases. As you’ve probably worked out by now, it’s Britain’s surging inflation.
The Bank of England’s official target for UK consumer price inflation (CPI) is a 2% annual rate. Less than a year ago, the Bank’s economists reckoned that the current CPI figure would be some way below that. So the last few months must have given them all a very nasty shock. British CPI inflation is now rising at 4.4% a year. Moreover, retail price inflation (RPI), deemed by many to be a better measure of the cost of living, hit 5.5%, its highest for 20 years.
Normally in such circumstances you’d expect to see the Bank’s interest-rate-setting Monetary Policy Committee (MPC) vote for a higher bank rate, to choke off price rises. But this is most effective when price rises are caused by a surge in domestic lending and demand. That’s not happening this time – in fact, consumer credit has shrunk by almost 2% over the last year. The problem for the MPC now is that British inflation is largely being driven by factors outside its control, such as soaring commodity prices.
So despite some slightly tougher talking by some MPC members, a near-term rate rise doesn’t look likely. In fact, with Bank of England governor Mervyn King terrified of being accused of sending Britain back into recession, inflation could climb yet higher before the MPC feels forced to snap into action. As our editor-in-chief Merryn Somerset Webb has pointed out several times, only the threat of rising wages (which could result in a wage-price spiral) is likely to persuade the MPC to raise rates significantly, if at all. There’s not much sign of that happening yet. Salary increases are lagging well behind inflation, which makes the squeeze on disposable incomes even nastier.
Inflation is bad for government too
Here’s the extra bad news on Britain’s climbing cost of living. Consumers aren’t the only ones being crushed by surging inflation – it’s squeezing the government too. If the coalition holds the line on its spending cuts in cash terms then, after inflation, the cuts will be even deeper. What’s more, inflation drives up government spending on any inflation-linked benefits, even though tax revenues aren’t rising at the same time. So inflation isn’t helping Britain pay off its debts as some assume. It’s actually making matters worse.
There’s another area where rising inflation is a growing threat. Let’s go back to those long-term borrowing forecasts that we mentioned earlier. The government still hopes to meet its target of cutting national debt as a proportion of GDP by 2015/2016. But the OBR now reckons UK borrowing will be higher than it previously forecast. The new numbers are ÂŁ122bn in 2011-2012, against the last estimate of ÂŁ117bn, falling to ÂŁ29bn in 2015-2016 (from a previous goal of ÂŁ18bn). Add it all up and you’re talking a national debt heading towards ÂŁ1.4trn and around ÂŁ370bn-worth of gilts that the Treasury will need to sell to plug the rest of this shortfall (any money that can’t be raised through higher taxes has to be borrowed). So Osborne must keep long-term gilt buyers sweet.
The good news is that, for the moment, Britain is broadly in the bond market’s good books. A series of global crises in 2011 has sent investors scurrying for safe-havens. Many have been happy to buy gilts, meaning we can still borrow money at around 3.5%. That’s very precious when you’re already paying ÂŁ50bn a year in interest payments, as Britain will be in 2011/2012. You only have to look at Portugal and Ireland – whose sovereign bond yields have climbed to 8% and 10% respectively – to see the damage that can be done if a country’s finances lose credibility in the market’s eyes.
But inflation is bad news for gilts, as it cuts the value of the income stream they provide (if inflation is at 5.5% and rising, why would you want an asset yielding 3.5% if you could find something better?). So if inflation keeps rising, gilt yields may be forced higher to compensate. That would mean Britain having to pay more – maybe a lot more – to service its debts. Britain could enter a vicious circle of rising borrowing costs and even tougher spending cuts to try to get its finances back on track.
To recap, then: the Budget is unlikely to make much difference to Britain’s economic problems. Our situation could yet get worse as we face a lengthy road of low growth and inflation (ie, stagflation) ahead. But there really is no alternative to austerity if the country is to break free from its state debt dependency.
Is there hope for Britain?
So is all hope for Britain lost? Not at all. Long term, our best hope is ultimately what the government is doing – managing to reduce the share of the economy that’s dominated by the state and encouraging business investment. Over time, that will allow more private investment to create the wealth that will generate both the jobs and the tax revenues the country needs.
But in the meantime, the prospects for most consumer-related companies aren’t great. That makes investment trickier than usual. Here are some of the safest UK stocks to hold.
Seven stocks for straitened times
Stock Ticker J Sainsbury LSE:SBRY Wm Morrison LSE:MRW Tesco LSE:TSCO Scottish & Southern Energy LSE:SSE National Grid LSE:NG RSA LSE:RSA Aviva LSE:AV
From an investment viewpoint, the most interesting news from the Budget was that National Savings & Investments will bring back its savings certificates in May. “We don’t yet know what precise rate will be offered on the new bonds,” says John Stepek in Money Morning. “But if they’re anything like the old ones (which generally paid 1% above Retail Price Index (RPI)inflation), they’ll be worth queuing up for.”
That’s good advice, because getting a decent return from the UK equity market is likely to prove a lot tougher than it has recently. The likelihood of household names reporting nasty shocks – and seeing their share prices hammered – has risen sharply. This means the best and safest companies to buy are ‘defensives’ that don’t rely on economic growth for their profits. In other words, we reckon the Budget doesn’t change the type of shares you should hold – and we’ll come to our tips in a minute. But to see what austerity really means for much of consumer-facing corporate Britain, you only need read the recent trading statements – and profit warnings – from the UK’s general retailers.
Take this week’s warning from Currys and PC World owner Dixons, the country’s largest consumer electronics retailer. Like-for-like sales over the last 11 weeks fell a staggering 7%. “Consumer confidence across some of our markets is fragile,” says Dixons’ boss John Browett, “and we expect [this] to continue through much of 2011.” It was bad for shareholders too – Dixons’ shares plunged over 10% on the news. Indeed, it’s small wonder Britain’s general retail sector is trading at a near-two-year relative low against the wider market. While it’s tempting to consider buying in on a contrarian view, we reckon it’s still too early.
However, there is a sub-sector of retail that does look worth buying: supermarkets. The retail malaise has dragged down the shares prices of supermarket chains too. And to be fair, these are subject to some of the same consumer spending constraints as general retailers. But even in tough times they’ve shown they can keep growing profits. Further, people cutting back are more likely to ‘one-stop shop’, which would boost supermarkets’ sales of non-food items at the expense of high-street rivals.
Looking at the valuations and yields on offer, there’s some great value around. The best all-rounder is J Sainsbury (LSE: SBRY), on a current year p/e of 12 – low by historic standards – with a 4.5% prospective yield. Wm Morrison (LSE: MRW) is even cheaper on a 10.5 p/e, and a 4% yield. Even Tesco (LSE: TSCO) has dropped to a sub-11 p/e and prospective yield of 3.7%.
With further inflation-beating dividend growth on the cards from all three, this could well be the time to buy.
The cut in corporation tax should also help the big blue-chip dividend-payers we favour generally. Long-term MoneyWeek favourites power utilities Scottish & Southern Energy (LSE: SSE) and National Grid (LSE: NG/) have done well recently.
But we reckon there’s more to come. Meanwhile, with prospective yields of 5.9% and 6.1% respectively, shareholders are getting a return above even British RPI. A couple of major British insurers are also near the top of the income list.
RSA (LSE: RSA) is on a current year p/e of below nine and is forecast to yield 7% this year. Aviva (LSE: AV/), on a 2011 p/e of seven and a 6% prospective yield, looks equally good value. Both stocks were recently hit by unjustified jitters over Japan – but that’s served up a handy buying opportunity.
Category: Market updates