Tuesday sees the emergency Budget being published by Chancellor George Osborne. This announcement and the measures contained therein, represents the beating heart of the coalition’s move into power at the expense of the Labour party. To say that they have staked their reputation on this is an understatement; the UK’s reputation is on the line as well. The rewards are clear: safety, calmer financial markets and a healing financial system.  The risks are also easy to see: a sovereign debt downgrade, a sterling crisis and mass civil unrest. Osborne’s schooling heritage is well publicised, however we are unsure whether tight-rope walking was an additional course at Magdalen College, Oxford.

I have listed below the major areas that I expect to be touched upon in the speech and the possible impacts upon the pound.

But first, some background:

• In 2009/10 the budget deficit was £156bn, 11% of GDP.
• In the same period the debt/GDP ratio stood at 70% with expectations from government that this would rise to 90% over the next four years.
• The general feeling is that to keep our credit rating secure we need to see 2.5%-3% cuts per annum over the next three years and the total deficit to below 3% before 2015. This equates to cuts of around £95bn-105bn.
• If these cuts were to come at the ratio used in the campaign, a ratio that I think will change in favour of higher taxation, (80% spending cuts, 20% tax rises) then that equates to, using the higher figure to price in some buffer, £84bn of cuts and £21bn of tax rises over the next five years.

So where is this money coming from?

Tax:

In the tax arena, I am looking for increases in the VAT rate, CGT rate and a newly installed bank levy. I do not expect any change in income tax, inheritance tax or corporation tax.

• VAT – Much has been made of a possible increase in VAT and the noise has become deafening given Cameron’s and Osborne’s refusal to rule it out. A rise to 20% (2.5% increase) would raise around £12.5bn in receipts and cost the average household around £425 extra per annum. This would of course be quite a controversial tax increase as it tends to hurt those on low incomes harder than those on higher. We do not expect currently VAT-exempt items (food, baby clothes, etc) to start attracting VAT however.
• CGT – Capital Gains Tax (currently 18%) is likely to increase closer to levels of income tax. Although this measure is not likely to be seen as a big money-spinner (every percentage point increase raises roughly £110m), this is likely to come in to ‘put a leash’ on the housing market and avoid bubbles by discouraging ‘buy-to-lets’ and second home property speculation.
• Bank Tax/Levy – This is very difficult to call as, although a globally agreed international measure, the decision of how it is enacted as well as how punitive it will be has been left to each individual nation. The ‘bonus tax’ on earnings over £150k has raised around £3.5bn but is unlikely to be extended and the shortfall is likely to be covered by this new levy.

Government spending:

Cuts in departmental spending were roughly announced in May and can be seen in the table below:

Source: HM Treasury, www.guardian.co.uk

These add up to comparative peanuts with the real crux coming from cuts in public sector pay and pensions; a prospect that has been greeted with promises of strike action from the public sector union, Unison. Public sector workers in Greece and Spain have already seen a 5% cut in their pay; those in the UK will be looking at something similar. The government is obviously not eager to announce the full table of cuts before the Budget announcement on Tuesday but if you include the ring-fenced NHS (1/6^th of government spending) and Social Security (roughly 1/3^rd), then most departments are looking at 20% cuts.

What will be the impact on sterling?

How the market, and the general public, reacts to Osborne’s day in the limelight is ultimately how the pound will trade moving forward. Leading into the announcement I expect the pound to lose ground on a trade-weighted index measure. This would be expressed by falls to around the 1.17 level for sterling/euro (0.8547 in euro/sterling terms) and to around 1.44 for sterling / US dollar.

Should the market and ratings agencies run their slide rule over the Budget and see figures that tick the boxes, I would expect sterling/euro to move back towards the 1.20 level fairly quickly (within one week). But, sterling / US dollar is another story and would probably take longer to recover due to the risk aversion qualities the US dollar possesses and my belief that equity markets will have a fairly poor summer session.

The problem of appeasing the ratings agencies however is that it is often to the detriment of the general public . I do expect we will see demonstrations/protests against the austerity measures; the Great British public is not one to lie down and take instruction from the powers that be. Whether this disquiet turns from protests to riots is something that must be priced in by the market. Riots over the measures would be seen on an international stage as a lack of acceptance and would in turn lead to price falls for UK assets (sterling lower, gilt yields up).  For the record, I do not believe we will see this type of unrest.

And so I conclude…

George Osborne needs to be like Goldilocks on Tuesday except he doesn’t have the luxury of being able to taste the first two bowls; it needs to be just right or sterling faces a very poor summer.

ENDS

What next?

• On Tuesday 22 June, Jeremy will be on twitter during the Chancellor’s speech. To see his tweets, click here: http://twitter.com/World_First
• After the Budget, Jeremy will also put together his thoughts and ‘The Budget – the aftermath’ will be released to you later on Tuesday afternoon.
• If required, we can put more specific comments and thoughts together for your readers. Please let Wendy Casterton know as soon as possible if you would like this.

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