The UK entered a period of heightened political and economic uncertainty following the EU referendum. But as the fog begins to clear, we are starting to see more clearly what might be on the horizon.
We downgraded our forecast for UK economic growth in the aftermath of the referendum. Our concerns have since receded, as domestic political uncertainty has diminished with the quick appointment of a new Prime Minister and a measured approach to EU relations.
On top of this, the Bank of England (BoE) has already delivered the vast majority of what we expected to see by the end of the year. It has cut interest rates, embarked on more QE by buying both gilts and corporate bonds, and eased pressures in the banking system, which further reduces the risks to the UK economy.
With the Autumn Statement looming, the next question is over what government action we can expect to see.
Businesses tell Chancellor: cut national insurance, not corporation tax
With new chancellor Philip Hammond saying the UK can “reset” budget policy if necessary, and the government abandoning its previous objective of balancing the budget by 2020, it looks like a significant government tax cut or spending stimulus is on the cards.
Could we see a budget boost of 2 per cent GDP? The BoE is buying £60bn of extra gilts, which is roughly 3 per cent of GDP. This buying absorbs the bonds that the government issues to pay for the deficit.
A weaker economy could lead to the government deficit widening by around 1 per cent of GDP versus what it could have been otherwise.
If the government thought it could increase spending up to the additional purchases from the BoE, it could have up to 2 per cent of GDP to play with. This is not how it has acted previously, as it was focused on returning to a budget surplus. But the UK Treasury is under new management.
So what options does the chancellor have? A VAT cut is a real possibility. This would be a quick and easy measure to implement and could give a short-term boost to the consumer.
It is also likely if the inflation increase from a weaker pound is high or consumer sentiment deteriorates. If the government chooses this option, 2 per cent of GDP roughly equates to VAT being cut to 17.5 per cent for two years.
What about a corporation tax cut? George Osborne talked about cutting this tax to 15 per cent, but it is already set to fall from the current 20 per cent to 17 per cent by 2020, so this would only be a small additional stimulus.
When it comes to other tax cuts, a stamp duty holiday or cuts for first-time buyers are also possible – though politically these could be difficult to implement if they are seen to be helping higher earners.
Of course, the government may also decide to get building. Additional government investment is likely to be more powerful than tax cuts, as the economy typically gets a greater boost per pound from direct spending.
Investment could span infrastructure projects, research and development programmes, and increased housing construction. From a longer-term perspective, this would improve the UK’s productive capacity.
The disadvantage is that the impact would be slow to manifest in real activity. However, it could help to shore up investment intentions in the private sector.
There may also be additional incentives for the private sector to get busy building, including housing construction and special infrastructure bonds.
Increased government spending (or tax cuts) would most obviously impact the mid-cap sector in UK equities, particularly stocks that benefit from infrastructure spending such as contractors and homebuilders.
The mid-cap FTSE 250 equity index sharply underperformed the large-cap FTSE 100 following Brexit: it is more exposed to the grassroots of the UK economy than the more international FTSE 100, and so should also benefit from any increase in government spending.
The Autumn Statement, scheduled for 23 November 2016, along with the Conservative Party Conference in October, are the window of opportunity for the government.
With that excitement on the horizon, it almost makes you glad summer is over.