Merlin Weekly Macro: The UK’s debt problem makes it vulnerable

‘To business, we have your backs! To working people, we have your backs!’ What goes through the Chancellor’s mind when she says such things? Perhaps she really believes it to be true? But her actions tell a different story.

Mind your back, more like

As of 6^th April, employers are subject to the new, higher National Insurance rate of 15% which is now levied from a baseline £5,000 of gross salaried income per employee down from £9,100. The minimum wage also increased by an average of 6.7% effective 1^st April. This neither ‘has the back’ of business whose direct costs have risen significantly, nor of workers when the rational response from hard-pressed companies is to seek ways of reducing the wage bill and to apply the brakes to recruitment plans. Angela Rayner’s new employment bill granting extended rights to employees might have current workers’ backs, but it is questionable judgement if the result is greater frictional costs to employers such that it lowers future employment prospects.

Relative degrees of pain

As for individual sectors, some are singled out for additional attention.

UK oil companies still endure surcharges to the standard corporation tax rate levied on ‘windfall profits’.

The motor industry is one of the few large-scale British manufacturing industries remaining. It is subject to Trump’s 25% tariff on car exports to the US which remains in place alongside the 10% national tariff and notwithstanding the President’s 90-day pause applicable to national surcharges; meanwhile, Jaguar Land Rover (JLR) as a purveyor of greenhouse gas-emitting vehicles finds itself subject to what is essentially a 100% tax on the price of SUV’s levied in France. Neither is the responsibility of the UK government. However, it is of very little consolation that here in the UK, and in a battle between pragmatism and principle and a concession to the pressure, the government has marginally relaxed its own punitive fines levied on domestic quota-busting sales of internal combustion engine (ICE) vehicles.

In 2025, a manufacturer must ensure that a minimum of 25% of all car/van units that it sells are electric vehicles (EVs): the quota bar (i.e. the principle) remains intact but this week the penalty (a pragmatic nod to reality) has been reduced by 20% from £15,000 to £12,000 per ICE unit that is in breach of the quota. The minimum EV percentages rise steadily to 100% by 2030 with the only exceptions being hybrids which may now remain available until 2035, or ICE models produced by small specialist manufacturers such as Aston Martin, Caterham and Morgan. When one of the chief constraints to the demand for new EVs is the lack of nationwide charging infrastructure, which is beyond the control of carmakers, it is hard to see how a reduced fine for not selling enough EVs can be construed as ‘having your back’. The policy automatically limits output if demand for EVs is insufficient as manufacturers try and avoid automatically forfeiting £12,000 per marginal unit sold as a fine payable to the government.

While some sectors are feeling more optimistic than others (housebuilders and construction, for example), few will be hanging out the bunting that the government ‘has its back’.  The government’s greatest excitement this week was the announcement of a new Warner Brothers theme park in Bedfordshire; it is to be built on an old brick works. How ironic that the project revolves around suspended belief and fairy tales; back on earth, despite self-sufficiency in brick-making raw materials, thanks largely to cripplingly high energy costs, the UK is perforce the world’s biggest importer of the very bricks it cannot manufacture to meet the domestic demand. 

Bond markets blow Rachel’s cover

This week saw ample demonstration of the lack of confidence that the Chancellor has either a grip on the current situation or a credible strategic plan for long-term economic recovery and sustainability. Amid the Trump-inspired extreme volatility seen in the past week across all international asset classes including sovereign bonds, UK government bonds¹ stand out as beacons of the lack of investor confidence in the government’s policy. The most obvious was the performance of the UK 30-Year Gilt: in the seven days spanning Trump’s Liberation Day and his Tweet indicating a 90-day pause, its yield² soared from 5.10% to 5.62%, the highest intra-day rate since 1998 and a full percentage point higher than in 2022 during the Liz Truss/Kwasi Kwarteng budget debacle (for the technically minded, the UK 30-Year real yield (which is adjusted for inflation) peaked this week at 2.33%; the 3.29 percentage point difference between that and the nominal yield of 5.62% represents the ‘risk premium’ applicable at the time covering the 30 year outlook).

Essentially, the significant risk premium distils down to a simple message: investors lending to the government on a 30-year outlook perceive a heightened risk that it defaults on the interest payments or, worse, reneges on the loan principal. That perception is fuelled also by the Bank of England’s Financial Policy Committee which this week reported: “Risks associated with debt sustainability concerns, including sharp increases in government bond yields, could crystallise relatively quickly, particularly if accompanied by rapid capital outflows. Increased debt levels and servicing costs for governments as debt was refinanced could also reduce their capacity to respond to future shocks”.

Do the math; join the dots

This is an old, long-running saw in these columns. We make no apology for banging on about it. That we need to arises from a combination of a lack of credible government response and a situation which is predictably deteriorating.

The Office for Budget Responsibility (OBR), the government’s own official arbiter of fiscal probity, is yet to update its long range fiscal forecast to 2075 (the most recent was published in September 2024). However, given all that has happened since the October Budget and the near-evaporation of Rachel Reeve’s fiscal headroom such that in the Spring Statement in March she was forced to find billions of pounds of cost savings to keep herself the right side of her own fiscal rules (‘sacrosanct’, said Starmer), it is unlikely that the outlook will have improved.

The numbers themselves will almost certainly be wrong (nobody knows accurately what will happen over 50 years) but it is the trajectory that is likely to be correct. Growth is modest. Based on what is known about current spending programmes and with no changes to current taxation structures, the OBR sees government outgoings and income receipts parting company from 2030 on rapidly diverging paths: on the one hand there are sharply rising health and state pension costs, and on the other a big fall in revenues from fuel duties. But one of the biggest increases as a percentage of gross domestic product (GDP) is debt interest payments: they rise from 4.4% of GDP (much as today) but then accelerate away like a runaway train such that by the mid-2050s they will be 6.5% of GDP and by the mid-2070s may reach 12.5% of GDP based upon a projected government debt figure of 270% of GDP (98% in 2024/5).

The mid-2070’s are half a century away: those entering the job market today may be retired by then; the author would be 112 but will more likely be surveying the wreckage from a cloud (optimistically). But what the OBR is pointing to and the Bank of England is concerned about is that the fuse has already been lit. In the absence of the government taking a radically different approach to how it manages its fiscal affairs, instead of being extinguished a slow-burning flame rapidly accelerates to the inevitable point of detonation. The longer we leave addressing the fundamental issues of public sector reform, which means providing services in a radically different way, the difficulty of restoration becomes much, much greater.

As the Governor of the Bank of England says, nationally we become far less resilient to economic shocks. Following swiftly from the pandemic and Putin’s invasion of Ukraine, we are already faced with another two: needing to find percentage points more of GDP to fund defence, and a burgeoning international trade war. That today’s circumstances illustrate the Governor’s point should be galvanising the government into action, precisely to avert what the Bank of England’s prognosis can be interpreted as being: a potential economic calamity. For the government, the penny is yet to drop; that its predecessors going back two decades also evaded responsibility merely leaves the incumbent in equally bad company. And until the penny does drop, the UK will continue to see its national funding costs charged at not only an avoidably high level but also a premium rate to most of our main competitors which actively compounds the problem. So much for ‘having our backs’.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each. With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

Sources

¹Government bonds are issued by governments.  Bonds are a type of fixed interest investment, in which a company, government or other institution borrows money and, in most cases, pays a fixed level of interest until the date when the loan is due to be repaid. 

²Yield is the rate of interest or income on an investment, usually expressed as a percentage.