Phil Milburn

Kicking the UK’s fiscal tyres

Phil Milburn

Anyone working in fund management needs to be constantly challenging their existing opinions by reviewing new information, from macroeconomic data series to company results. We should also be highly cognisant of our own biases; personally, I will always read any research piece that disagrees with my view. You can be passionate about investment and still objective about analysis.

As the eligible UK population return to the polls on 12 December, it seems objectivity has been thrown out of the window in a country that remains passionately and deeply divided. Pledges to spend society’s tax revenue have escalated as political parties pitch to marginal voters and/or impose their ideology on their party’s manifesto. 

You will be relieved to hear I am not going to inflict any of my political opinions on you; instead I will objectively look at the state of UK government finances and reflect on the evolution of aggregate figures in the post-war period.

There are so many different terms and definitions used when examining fiscal policies but it really all boils down to government revenues and expenditure. Total government revenues are mainly formed by tax receipts with all our UK favourites such as income tax, national insurance, VAT, corporation tax and so on. Government expenditures are also self-explanatory, but I will expand on a few nuances later.

UK government revenues and expenditures (% GDP)

Source: OBR, Liontrust, to 22.11.19

The graph above shows the aggregate numbers as a percentage of GDP. It can clearly be seen that spending exceeds receipts most of the time. The difference between spending (gold line) and revenue (green line) is referred to as the fiscal deficit and is also known as public sector net borrowing (PSNB). This is also shown on the chart below:

Public sector net borrowing (% GDP)

Source: OBR, Liontrust, to 22.11.19

The fiscal deficit can be broken down into two components, the primary fiscal balance, which excludes interest on government debt, and interest costs themselves. I am old fashioned and would classify a balanced budget as one where the PSNB is zero; others focus on the primary fiscal deficit. 

Other wiggle room is created by classifying expenditures into current and capital investment and only then committing to running a balanced budget based on the current expenditures. 

Ultimately, all prior fiscal deficits have been funded with debt and the cumulative sum of this effectively becomes the public sector net debt. This is shown relative to GDP on the chart below:

Public sector net debt (% GDP)

Source: OBR, Liontrust, to 22.11.19

If a capital investment by the government can raise the potential GDP of the economy or boost productivity, then it can be easily justified; this is due to the denominator in the debt to GDP equation. Whenever nominal GDP grows rapidly, and there is a minimal deficit, the proportionate debt burden rapidly decreases. The 1950s and 1960s were mainly characterised by this economic environment.

The burden of any overspend is borne by future generations of taxpayers, thus they are the judges of whether any prior period’s overspend was worthwhile.

Keynesian economists look to fiscal spending to provide counter cyclical boosts to the economy and thereby cushion activity levels in society. Some of this is through automatic stabilisers such as the social security “safety net” and some through the timing of capital expenditures on infrastructure projects. 

John Maynard Keynes himself did advocate a balanced budget on average through the whole economic cycle, but once a government has discovered the proverbial drug of overspending, it is hard to ween them off it.  Nowadays, a fiscal deficit and growing absolute amount of government debt is accepted provided the sovereign credit metrics are deemed sustainable with its debt to GDP ratio staying steady or declining. The Maastricht Treaty, or the Stability and Growth Pact part of it to be more precise, specifies that an excessive fiscal deficit is anything over 3% of GDP and total government debt should not exceed 60% of economic output.

In the UK, the Conservatives accuse Labour of being fiscally lax but the recent retort is that the national debt has doubled in the nine years the Conservatives have been in charge. In objective terms, both sides of the equation can be correct, and it is about using selective statistics that suit your particular viewpoint. 

In the chart below, I have copied the revenue and expenditure lines from the first chart and overlaid it with which party was in government at the time of that year’s budget. Note that for ease of presentation, this includes minority governments and the 2010-15 coalition is classified as Conservative as the they were the dominant party within it.

UK Government revenues and expenditures (% GDP)

Source: OBR, Liontrust. Pink bars show periods of Labour government, blue show periods under Conservative rule. To 22.11.19

The “great financial crisis” of 2007-09 created a deep recession. Government expenditures as a percentage of GDP ballooned so much so that when the government changed in 2010, the new chief secretary to the Treasury infamously found a note left by his predecessor saying, “Dear chief secretary, I’m afraid to tell you there’s no money left.”

Whether this was due to the government having squandered spending during the preceding years, the financial sector’s fault or a combination of the two is more subjective than objective and every reader will have their own view. What is certainly true is that a 10% fiscal deficit is not sustainable, it would bankrupt most emerging market economies, so something needed to be done about it. 

The reduction in the fiscal deficit is commonly referred to by the term austerity. Technically, this is a misuse of the word as the government is still spending more than it is earning so there is an additional flow of debt into the outstanding stock; however, austerity has now become synonymous with spending cuts and it’s not a bad proxy. 

The reason for this is the Conservative ideology of the small State and how the decrease in the deficit was achieved. The tax take was raised from 36% to 37% of GDP but the majority of closing this gap was through spending cuts. 

From the 2009-10 peak of almost 45% of GDP expenditure level, government spending has contracted to just above 38% in 2018-19 and is forecast to be a similar level for this fiscal year. With certain parts of the budget having effectively protected status, this means the cuts on what is referred to as discretionary spending have been particularly draconian. Again, I am avoiding judgment in this piece on whether such spending cuts were the right or wrong thing to do.

A brief examination of the manifestos of the two largest parties, as well as all the other significant UK political parties, shows spending is likely to increase no matter who wins the election. We remain very cautious about owning any UK Gilt duration exposure within our Liontrust strategic bond funds: sterling-denominated credit contributes UK interest rate risk to the funds, which we hedge out using liquid government bond futures.  

There are two factors that prevent us from having a large short duration position in the UK relative to other more attractive bond markets: first is the global industrial production malaise caused by the trade and tariff wars and second is Brexit.

If the Conservatives achieve a majority then the objective most likely scenario is that Boris Johnson’s Withdrawal Agreement passes through Parliament but a new trading relationship with the EU27 is not agreed within the truncated 2020 timetable and the UK crashes out at the end of the 2020 transition period. For the foreseeable future, politics will continue to be a huge driver of asset prices, we will continue to examine the actual evidence to generate performance for the funds.

For a comprehensive list of common financial words and terms, see our glossary here.


Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Global Fixed Income team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The value of fixed income securities will fall if the issuer is unable to repay its debt or has its credit rating reduced. Generally, the higher the perceived credit risk of the issuer, the higher the rate of interest. Bond markets may be subject to reduced liquidity. The Funds may invest in emerging markets/soft currencies and in financial derivative instruments, both of which may have the effect of increasing volatility.


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Monday, December 9, 2019, 11:13 AM