Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
Recently fuelled by optimism over the advent of coronavirus vaccines, the stock market was required this week – just for a moment – to pause to count the economic cost of the pandemic. The government’s spending review laid bare the damage to economic output and jobs, which will almost inevitably lead to higher taxes and more public borrowing.
The Chancellor’s speech was far from sugar coated. Characterising the future the country faces as “an economic emergency”, Rishi Sunak went on to say government borrowing this year (£394 billion) would be at its highest as a proportion of economic output in peacetime history and that, according to the Office for Budget Responsibility, unemployment could reach 2.6 million people (7.5% of the working population) by next summer.1
Mr Sunak confirmed the price still to pay includes a public sector pay freeze – except for NHS workers and the low paid – along with a temporary cut in overseas aid. However, these moves are relatively small drops in the fiscal ocean.
More was left until the Budget next March. The Chancellor’s commitment to return the country to a “sustainable fiscal position” once the economy recovers means much more significant measures, including tax increases, are surely in the pipeline.
The Chancellor will be hoping that a bounce back for the economy – growth of 5.5% next year then 6.6% in 2022 according to the OBR – will help soften the blow of the tax rises that are coming and reduce their required size.
Given the amounts needed to make enough of a difference, none of the Exchequer’s three main sources of income – income tax, national insurance and VAT – now seem safe from a future claw-back of funds.
The economic headroom required to address the pandemic has, so far, come from increased public debt. The country’s total debt will be 91.9% of economic output this year rising to 97.5% in 2025-26, putting Britain in the same sort of league as the US.
While there seems to be no political will to balance the country’s books at the moment, the UK government could be hurtling to somewhere between a rock and a hard place. To avoid major cuts to public services, it must either plug the widening hole in the public finances by putting up taxes or kick the can further down the road by borrowing yet more, or a combination of both.
Previous evidence, gathered in more normal economic times, points to an inverse relationship between tax rates and the Exchequer’s tax take. Higher taxes have an unhappy knack of deterring certain types of work and investment, in turn, depressing economic output. The danger now is that, with confidence about jobs and the economy already low, higher taxes at this point would risk forcing businesses and consumers to retrench.
That said, even with increased taxes, the UK looks set to remain hostage to rapidly increasing levels of public debt for the foreseeable future. Borrowing is expected to be in excess of £100 billion per annum for the remainder of this parliament.
That’s a worry because, while the government can issue debt in the form of gilts reasonably painlessly at the moment owing to record low interest rates, the cost of borrowing is very likely to rise as gilt investors demand higher yields in future in exchange for accepting the inflationary risks that normally accompany an economic recovery.
Not only that, as the economy cycles deeper into recovery mode, the Bank of England is likely to withdraw as a major buyer of gilts, which it currently is by virtue of its quantitative easing programmes.
While the OBR expects debt interest as a proportion of national output to fall this year,2 that could reverse in future years as the government refinances existing debts and has to issue more gilts to fund new borrowing. That could leave it – over the medium term – with less to spend on the things it would like to do more of – like more funding for infrastructure projects and building a greener economy.
On which, the spending review gave some sort of order to the Chancellor’s more immediate priorities. The health crisis means £18 billion will be spent on Covid-19 vaccines, testing and PPE equipment over the next year, with potential benefits for a host of pharmaceuticals and biotechnology companies, large and small.
Recent pledges by the prime minister to renew the UK’s nuclear deterrent and build more ships followed this week by the spending review’s promise of an additional £24 billion in new defence spending over four years suggest an increasingly healthy order pipeline for defence contractors such as BAE Systems and Babcock.
The UK’s large construction engineers like Balfour Beatty and Costain will welcome the government’s £100 billion capital spending commitment for next year and a £4 billion “levelling up” fund to finance local infrastructure projects in England.
House builders stand to benefit from the introduction of a £7.1 billion national home building fund, although the positive effects of that could be outweighed in the short term by fears the housing market will move into retreat once the Chancellor’s stamp duty tax holiday and furlough schemes end next spring.
Having sprung back to life earlier this month on news of positive progress towards three workable Covid-19 vaccines, shares in economically sensitive UK companies should be buoyed by the growth rebound anticipated by the OBR over the next two years, as well as the Chancellor’s latest spending announcements.
However, given continuing uncertainties over how quickly the economy can actually bounce back from its 11.3% contraction in 2020 with the health emergency still in full flow and restrictions on the activities of workers and consumers likely to last well into next year, it still makes sense for investors to adopt a balanced approach to the types of companies they invest in.
Special situations funds and UK equity income funds using a value-based methodology may have a lot to gain from a post-Covid world of new growth and investment. One example, the Fidelity Special Situations Fund, focuses on businesses undergoing positive change yet to be recognised by the wider market. Legal & General, the public services provider Serco and construction company John Laing are among its largest investments currently.
The Fidelity UK Select Fund, on the other hand, favours businesses with strong brands and robust balance sheets that can grow even when economic conditions are difficult. Particular attention is paid to the competitive environment in which companies operate and the potential for disruption through the arrival of new technologies or businesses. Unilever, Reckitt Benckiser and the plumbing supplies group Ferguson feature among the Fund’s largest investments.
1,2 - Gov.UK, 25.11.20
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy or sell a fund. The Fidelity UK Select Fund invests in a relatively small number of companies and so may carry more risk than funds that are more diversified. The Fidelity Special Situations Fund and Fidelity UK Select Fund can invest in overseas markets, so the value of investments can be affected by changes in currency exchange rates. Both funds use financial derivative instruments for investment purposes, which may expose the funds to a higher degree of risk and can cause investments to experience larger than average price fluctuations. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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