Chancellor Philip Hammond’s speech at the Conservative Party Conference last week confirmed a change in economic direction. Although he continued to talk of fiscal consolidation, there was a loosening of the purse strings for infrastructure development and housebuilding projects, and he reiterated that he would not target a budget surplus by the end of this Parliament.
The early reaction in markets has been difficult to discern amid the ‘flash crash’ of sterling and the concern surrounding the increasingly likelihood of a hard Brexit. Stock markets have continued to climb higher, but more on currency factors. What might the longer-term hold?
In turning his attention towards fiscal policy as a tool for boosting the UK economy, Chancellor Hammond is following the Japanese government, which recently announced a ¥28.1 trillion ($276 billion) stimulus package. This is also being targeted at infrastructure spending, though some will also go to local councils.
It seems likely that a Trump government in the US would also target fiscal spending, and Europe may follow suit.
New Infrastructure Spending
Why this new emphasis on fiscal policy? Ian Stewart, chief economist at Deloitte says: “Fiscal policy offers an alternative way of boosting growth, and with financing costs that are lower than for centuries. The private sector pays the German and Japanese governments for the privilege of lending them money for ten years. The UK, despite slow progress in cutting borrowing and a post-referendum credit downgrade, can raise money at the lowest rates in history, at a cost of just 0.8% a year.
“Surely, the argument runs, governments can find public sector projects – such as infrastructure or education - which will give society a higher return than the vanishingly low cost of capital and, at the same time, will boost demand?”
Darren Williams, European economist at Alliance Bernstein, is clear what this new emphasis would have meant in the ‘old world’ of economics: “Fiscal policy would usually mean that monetary policy could be less expansive. There could be less quantitative easing and an end to lower interest rates. This would be good for growth.
“However, this is the wrong way to think about it. Monetary policy is reaching the end of the road and it will not be either/or, but more likely, there will be both. No country is in a good place and most cannot afford to see yields rise.”
What's Next for Bank of England’s Quantative Easing Programme?
Daniel Morris, senior investment strategist at BNP Paribas Investment Partners, says: “The dynamics would be more spending, more debt, more inflation and that should see yields rise, but the question is whether the Bank of England would step up quantitative easing to push yields lower. This very much depends on the outlook for growth.”
For fixed income markets, this means no immediate spike in government bond yields, but it may well mean more volatility as markets work out the likely implications of higher borrowing. James Klempster, head of portfolio management at Momentum Global Investment Management, says that any impact is likely to be slow to make itself felt: “Monetary policy works quickly, but fiscal policy can be like pushing on a string. A large infrastructure project can take time to get going and might be several parliaments down the road.”
Equity markets may rally because more is being done to boost economic growth, as they have done with each wave of monetary policy. Williams says: “At least with fiscal spending measures, the money is definitely spent. The transmission mechanism to the economy is more direct.”
This may prove particularly important for shoring up the UK economy in the wake of a Brexit. Williams says: “It is not a panacea, but if there is a demand shock, it is sensible to be spending more money to support demand.” That said, Morris points out that one-off fiscal spending may not achieve that much, and the UK Government can’t afford to keep it up over a longer period of time.
Future Boost For Housebuilders and Retailers
Any fiscal spending programme may also benefit certain individual companies. For example, housebuilders should receive a boost (though the shares of UK housebuilders have been steadily falling since the Chancellor’s speech on Monday). There has been talk of the Chancellor cutting VAT, which could stimulate the retail sector. Klempster is wary of predicting outcomes for different sectors, saying it will depend on the extent and nature of the measures announced.
However, he points out that the new emphasis on fiscal policy may indicate that policymakers are losing faith in the ability of monetary policy to deliver economic growth. If this is the case, interest rates may drift higher. This would hit ‘duration’ assets – infrastructure, government bonds, and equities with ‘bond like’ qualities such as utilities.
This is a new era of policy: The impact of quantitative easing on markets is a known quantity. Fiscal spending is not. And just as with quantitative easing, the normal rules of economics may not apply.
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