UK Budget holds the ship steady, keeping our Gilt preference intact

The UK’s Budget of 30 October should boost growth while creating a small increase in inflation. We examine the macroeconomic backdrop and our preferences within UK assets.

The Budget was the first from the new Labour government, which came to power in July with a large majority and a promise to reinvigorate the economy. It implemented many of Labour’s campaign pledges to invest in public services and infrastructure, and to provide clear rules on tax and spending.

Most of the announcements in the Budget – including some tax-raising measures and changes to the country’s fiscal rules – were broadly expected, having been heavily trailed in the media. As promised, income tax and value-added tax (VAT) levels were left unchanged. Instead, Rachel Reeves, the Chancellor, raised capital gains tax from 10% to 18% in the lower rate and from 20% to 24% on the higher, and employers’ contributions to worker’s National Insurance payments, which help pay pensions and other state benefits, from 13.8% to 15%. This kept a campaign pledge not to raise workers’ National Insurance contributions, and we would expect the inflationary impact to be limited as companies are likely to absorb a part of the associated costs.

This year’s Budget was made easier by somewhat stronger-than-expected growth and relatively high inflation, which raised nominal UK Gross Domestic Product (GDP), giving the government more money to spend. Crucially, the Chancellor also changed the government’s self-imposed ‘fiscal rules’, which are policed by the independent Office for Budget Responsibility (OBR), helping raise public investment at a time when debt is already high.

The net effect of the new Budget measures should be positive for growth

Previously, the main fiscal rule stated that government debt should be on course to fall as a share of national income in five years. The Chancellor’s new ‘investment rule’ keeps the idea of debt falling as a percentage of GDP but changes the timeframe to this term in parliament (also typically five years) and changed the measure of debt to account for illiquid financial assets, such as equity holdings and loans. This gives the government around GBP 50 billion in extra funds by the end of the decade, which will be invested primarily in infrastructure, with new bodies set up to scrutinise spending. Ms Reeves also announced a new ‘stability rule’ requiring day-to-day government spending and the interest on national debt to be matched by revenues – justifying the tax rises.

The net effect of the new Budget measures should be positive for growth, thanks to the increases in public spending. They should benefit certain sectors, including green energy, transport and infrastructure and the country’s National Health Service, a huge employer. The latter should have positive effects on the UK labour market. It may also help address an acute problem affecting UK workers and the economy – high rates of long-term sickness and absence from employment, which have risen sharply post-pandemic. We expect the impact of the new Budget measures on inflation to be relatively small, because while some measures boost demand, they have also been offset by tax increases.

We expect the impact of the new Budget measures on inflation to be relatively small

Got to admit it’s getting better

Both UK growth and inflation dynamics had already surprised positively in 2024. Our full-year growth assumption is now 1.2%, and our forecast for 2025 is 1.5% - and now likely to come higher than that given the growth boost from the Budget. Indeed, the UK economy saw one of the biggest growth upgrades of any country in the IMF’s World Economic Outlook update of
22 October.

While higher nominal growth has given the new government more fiscal headroom, lower-than-expected inflation has given the Bank of England (BoE) more scope to ease policy, which it did for the first time in July 2024. Headline inflation fell below the BoE’s target in September, with core and services inflation – which has long been too high – also moderating. Although the headline measure could rise slightly in coming months, we expect additional cuts of 25 basis points at the two remaining BoE meetings this year, in November and December. Governor Andrew Bailey supported this view when acknowledging that inflation has fallen faster than the central bank had expected.

We also expect the BoE’s rate-cutting cycle to continue further, until it reaches a terminal, or end-cycle policy rate of 2.5%, although the pace may be slower than we previously expected depending on how the BoE assesses risks to inflation from the Budget. This is below market expectations, which are closer to 3.5% – although in recent months these have increasingly aligned with our own view of more cuts ahead.

We expect the BoE’s rate-cutting cycle to continue further, until it reaches a terminal, or end-cycle policy rate of 2.5%

Still favouring Gilts

How will the Budget affect the Gilt market? The pre-announcement of a change to the fiscal rules in the media on 24 October caused UK Gilt yields to rise, on a day when those of other developed market sovereign bonds were falling. Memories of a disastrous spike in Gilts following the announcement of unfunded tax cuts from Conservative premier Liz Truss in 2022 loomed large.

While we expect Gilt issuance to show a small rise given the new spending announced in the Budget, we think the market has ample capacity to absorb the extra supply. Within our sovereign bond allocations in portfolios – which we keep at strategic levels – we prefer Gilts and German Bunds to US Treasuries. Our preference for Gilts is based on a more aggressive BoE rate-cutting path than the Federal Reserve, as well as resilient UK growth prospects, ongoing disinflation and normalising labour markets. We see two-year Gilt yields falling to 3.8% three months from now and to 3.35% in 12 months.

Our preference for Gilts is based on a more aggressive BoE rate-cutting path than the Federal Reserve, resilient UK growth prospects, ongoing disinflation and normalising labour markets

Staying cautious on sterling

Conversely, we remain cautious on sterling. The currency had dipped against the US dollar in the weeks leading up the Budget, on both Budget uncertainty and haven demand for the dollar ahead of the US elections. However, earlier in the year it had been one of the strongest performing major currencies, amid positive investor sentiment given better-than-expected growth, fast-falling inflation and a new government. However, still weak trends in the current account, foreign direct and portfolio investment suggest most of this currency support was due to speculative inflows. These are unlikely to be repeated if, as we expect, the BoE cuts rates by more than the market is currently pricing. We see sterling remaining at current levels of around 1.30 against the dollar on a three-month horizon. Meanwhile, we are neutral on UK stocks – where companies are more dependent on the global rather than the UK macroeconomic outlook – given better earnings prospects elsewhere.