This week’s figures for UK public borrowing were bad. Market expectations were far too optimistic. Compared to the first four months of the previous financial year, revenues were down by £21 billion and spending was up by £19 billion. The UK government needed to borrow another £8 billion in July, a month when normally the government has a comfortable surplus.
As we have been warning, we should expect more of the same in the months ahead. The economy is still weak, and more people are likely to lose their jobs. This is not a good background for increased spending and more demand. The VAT reduction ceases at the end of the year. The UK banks remain under pressure from the authorities to raise their cash and capital levels or to reduce their lending. They too do not offer an easy way of increasing private sector demand. Over the next few months the government will continue to be the spender and borrower of last resort.
Why does this matter to investors? Isn’t it what they should be doing at a time of recession? Yes, they do have to spend more to deal with the casualties of the recession. Benefit spending does go up as more people lose their jobs, and revenues do fall as output and profits fall. Most governments use the so called automatic stabilisers by allowing more borrowing to cover these costs and losses.
The increases in spending and the fall in revenues become a problem if the amounts that need to be borrowed become too large. If markets start to think the government cannot control its deficit, then investors will demand a higher rate of interest for the risk of lending. The higher rate will mean yet more public spending to service the debts. It may also mean a general rise in interest rates, which will hit private sector borrowers as well. So far the UK government has been able to borrow at relatively low rates, thanks to two favourable forces. The first is the programme of buying its own bonds, which has helped keep the rates down below where they would otherwise be. The second is that most market participants think the government elected probably in May 2010 at the next General Election will rein in spending.
It is difficult to see how the UK can avoid some further increases in government borrowing rates, given the large sums involved. This means we continue to be negative about gilts, whose prices fall as interest rates rise. It is also difficult to see how the UK private sector can expand rapidly in domestic markets against this background of public sector crowding out. The weak position of some of the banks reinforces this view.
World markets have had a wobble over the last couple of weeks. They have run up rapidly on the back of rapid money supply growth in China and India, and as a result of the large quantitative easing programmes of the USA and the UK. Reality has to catch up. The reality remains that the growth prospects for the USA and Europe are weak, whilst India and China still offer the best prospects despite the sharp decline in export opportunities. We think equity portfolios should reflect this differential outlook. New investors should be careful about when they commit money, as valuations are now building in quite a lot of good news and recovery prospects.