Merlin Weekly Macro: Reeves in a budget bind

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Rachel Reeves: a Chancellor under pressure

Breathtaking. Unabashed. Two adjectives which accurately describe Rachel Reeves’s impromptu and unprecedented pre-Budget speech. A competent Chancellor in command of her brief would not have been standing there at all. October 30th last year saw a proud, confident, smiling Rachel Reeves approach the Dispatch Box to deliver her first Budget (the writing was quickly on the wall, however: having commended the Budget to the House she was battered in a blistering response by Rishi Sunak in the finest performance of his career, which left her looking shocked and knowing she and her “Securonomics” had already been rumbled); contrast with this week revealing a Chancellor under pressure, looking tired, gaunt and hunted. Introduced as being intended to quell speculation about tax rises, her briefing did nothing of the sort. It was impossible to escape the conclusion that here was a Chancellor getting her excuses in early. 

Breathtaking! Her flat declaration that her first Budget had “fixed the government’s finances” and put them on a “sound footing”. What she was referring to was raising £40 billion in taxes to plug the politically contrived “£22 billion unexpected black hole” she claimed she had inherited unwittingly from the Conservatives. Pure political sophistry, her statement can be dismissed out of hand. If the government’s finances are “fixed”, then why was she making a long circular statement about “hard choices” ahead of the forthcoming Budget if the media speculation about a new, unplanned government fiscal shortfall ranging from £20 billion to £55 billion was incorrect?

Unabashed! This was a masterclass in self-exculpation. The new deficit and the haemorrhage of cash that requires urgent plumbing is everyone else’s fault: Brexit and Farage; the Tory years of “chaos” and mismanagement; Lizz Truss warranted a personal mention; low productivity; defence spending; and the new unwelcome tumbleweed which has blown into town in the shape of Donald Trump’s tariffs. All, and more, are to blame. As for her own budget policies introduced last year? Not a single acknowledgement that the hike in corporate taxes and employment costs, or the breaking of enduring capital in small businesses and farms might have anything to do with undermining competitiveness, investment, confidence and growth. In its October policy statement when it kept interest rates on hold at 4%, the Bank of England specifically warned of the risk to future growth from further tax rises; next time, if the Bank’s warnings become reality, Reeves has nowhere to hide from the accusation that she too is the problem.

Correctly identifying issues without solutions to match

More positively, markets can now be in no doubt that the penny has dropped in the Treasury that government debt at 94% of GDP is too high and the cost of funding it, currently 10% of all tax receipts, is a significant constraint on public sector spending. Further, that Reeves is explicit (mind you, she was equally explicit also on her tax promises!) that her fiscal rules are sacrosanct: day-to-day government spending will be covered by tax receipts while capital investment will be funded by borrowings. She accurately identified productivity as a problem, particularly in the public sector. 

However, she herself has contributed directly to that blight when immediately on assuming office after the election, she precipitously agreed to make large unconditional pay awards to public sector workers, notably doctors, nurses and train drivers; it will not be lost on anyone that the junior doctors are already back for more, scheduled to take new industrial action, and the nurses are threatening it. The Chancellor’s speech made it clear that her number one priority is more funding for the NHS: to what and whose benefit is debatable. Her productivity reference also shines a light on those Labour local authorities who are intent on introducing a four-day working week for five days’ wages for council workers.

As the government has been swept along amid the shifting sands of geopolitics, Reeves supported the case for more defence spending. She has no choice despite a year ago maintaining that “there is no more money for defence”; over the next decade she must find a minimum of an extra one-and-a-half percentage points of GDP to meet our new NATO spending commitment. Under the 2025 Strategic Defence Review, the Chancellor of the Exchequer and the Defence Secretary are co-chairs of the new Growth Defence Committee; it is unfortunate that in the first year of the new regime, the MoD budget is allegedly already more than £2 billion overspent with six months of the fiscal year still to run. While Reeves pointed to the importance of national security, the order has already gone out from the MoD to the service chiefs to cut in-year costs, including the operational training and fuel bills being put at risk. It is a statement of the obvious that if we know that, so do the Russians and the other members of the Axis of Disruption.

The political calculation

Chancellors only have two levers to pull: the revenue raising lever which includes all areas of taxation; and the spending lever which defines departmental budgets. A budget surplus offers choices including whether to give money back to taxpayers; a deficit prescribes spending constraints and relies on extra borrowings to fund the shortfall. Reeves keeps inadvertently running out of road between income and expenditure. She is determined not to repeat “Austerity” with public services and spending: the connotation with Tory Chancellor George Osborne’s programme of cuts is too politically loaded.

Aside from government interest costs, by far the two biggest spending bills are the health service and welfare: the former she has earmarked for more money; the latter she cannot cut in any meaningful way because Labour backbenchers will not let her. But the Left still firmly believes in the concept of Modern Monetary Theory of public spending for the public good; those MMT initials are also known colloquially as the Magic Money Tree. In the days before the Covid/Ukrainian inflation hump and the big rise in interest rates, governments, investors and electorates were seduced into thinking that a prolonged period of zero interest rate policy would endure: money could be borrowed for free with no consequences. That notion has been disabused brutally with the more than doubling of annual government interest costs in little more than half a decade such that today at over £100 billion they are the equivalent of 10% of all annual tax receipts and 4% of total GDP. It is an unsustainable situation. Reeves understands hers will be the shortest plank-walk to political perdition if she decides to confront the bond markets head-on by reversing the commitment not to break her fiscal rules.

With virtually no political room for manoeuvre to cut expenditure to any significant degree, the Magic Money Tree requires a new source of nourishment. It comes from taxation and squeezing the rich (those with the “broadest shoulders”) until the pips squeak (“paying their fair share”). The Resolution Foundation-heritage fingerprints of the new economic advisers appointed by Starmer in September are all over what is being contemplated in the Budget; for them, wealth redistribution and equalisation are an ideological belief, not merely a means to plug a fiscal hole. The political calculation is simple and cynical: few will be harmed, many will benefit; those with the most to lose don’t vote Labour; those with the most to gain either do vote Labour or can be persuaded to again if they are currently flirting with Reform or the Greens. Politically, a fight with the bond markets will be as summarily terminal and fast as it was for Truss and Kwarteng if Reeves breaks her fiscal rules; even if it means breaking cast-iron promises and manifesto commitments, better to play Russian Roulette with the electorate and hope the pistol chamber is empty in 2029 when the trigger is pulled in the next election. That such policies are socially divisive and economically reductive is irrelevant.

A study in imbalance

None of which solves the UK’s enduring, structural systemic problem: we have a profoundly unbalanced economy. We are developing an over-reliance on the public sector particularly for marginal employment; we have too many people of working age who are economically inactive and too many who depend on benefits for their income; the private sector is heavily over-reliant on services and is under-invested and under-represented in manufacturing from both of which flows a constant current account deficit and an imbalance between imports and exports; we have a gross imbalance in the taxation system under which the over-reliance on a very small proportion of asset-rich and well-paid people to pay a disproportionate percentage of income and capital taxes is a structural weakness and a threat to sustainability.

Labour clearly has no intention of effecting fundamental repair. That challenge is for whichever government comes next.

The political consequences

Whatever the political calculations as outlined above, the consequences are already apparent, acknowledging that many factors other than simply the economy are at work (e.g. immigration, Palestinian politics, climate change etc). According to the current polls, as the UK political scene rapidly evolves and splinters we are witnessing the old Two Plus One system that has prevailed for a century being radically challenged. Reform (30%) leads Labour and the Tories sharing 17% each; but in a notable development at a national level, this month for the first time the far-left/Marxist Green Party (15%) under new leadership has overtaken the so-called soft left LibDems (13%).

Much may change between now and then but 2029 is shaping up to be the most fascinating, controversial and least predictable election in our lifetimes with all the investment risk that goes with it. We are not making bets with the Jupiter Merlin Portfolios but the prospective political environment is certainly on our radar. 

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.