The list of jobs I am pretty sure I would never volunteer for is long – though HGV driver is not as far down the list as it once was. But close to the top is chancellor of the exchequer – now more than ever.
Rishi Sunak has a horrible job; he needs to get the UK’s mad borrowing and spending levels under control, but he also needs to find a way to finance our relentless demands – from net zero and healthcare to pothole-free roads – while making sure his hints of tax cuts to come are vaguely convincing.
So far none of this is going madly well, but it’s not quite as bad as it looks. As George Bull of RSM, an accountancy firm, points out, gross domestic product (GDP) has rebounded smartly from last year – it was a mere 2.1% below its pre-pandemic levels by the end of July – and tax revenues will follow.
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That said, “not quite as bad” is not the same as not bad; it is bad. The UK’s debt-to-GDP ratio is 106%. A 2013 study from the World Bank suggests that once government debt goes over 77% of GDP every additional percentage point reduces real annual GDP growth by 0.017 percentage points. At 106% that adds up – its effect on living standards might be why Sunak said at his party’s conference this week that he considers the ongoing piling up of debt to be “immoral”.
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Tax rises will come
All this suggests more taxation. But what sort? We already know that national insurance is to rise, supposedly to pay for social care. On top of that there are suggestions that council tax will have to increase even to keep essential services on the go -– the Institute for Fiscal Studies reckons on a 5% rise by 2024-2025. There are also expectations that the chancellor will soon set out views on reform (for which read increase) of capital gains tax. Meanwhile, the idea that the UK’s well-off should pay another wealth tax (capital gains tax, inheritance tax and stamp duty are all wealth taxes) is not going away.
There are also probable new taxes on employment ahead. Lord Wolfson, chief executive of Next, suggested a simple solution to our labour shortage this week: business should be able to sponsor as many work visas as it likes – but pay a 7% tax on wages for the right to do so. That idea makes some sense.
More subtle is the promised rise in the minimum wage. The UK state currently subsidises the wages of the low paid via the universal credit system – in July this year 5.9 million people were claiming benefits this way. Put up the minimum wage and you effectively transfer the cost of much of that subsidy to companies. That’s not a bad thing, as the state subsidising wages is odd. But the effect is the same as if, say, employers’ national insurance was raised (again).
There are various other tax changes that could help Sunak out a little: think pensions – put in what you can while you can. But in the end political reality will mean that really big new taxes aren’t possible – the UK tax burden is already set to hit a 70-year high.
Inflation – the oldest tax of all
This means that the government is likely to end up relying on the oldest tax of all to erode the value of our debt relative to GDP – inflation. There is a lot of this about – and it looks less transitory by the day: a third of businesses in the UK say they are seeing the prices of materials, goods and services rise. We’ve moved from the explanation for this being the base effect (the oil price moving from around zero in March 2021 to $75 a barrel today, for example) to it being all about short-term supply crunches.
Both are perfectly reasonable explanations: after all, once we have been through a period of adjustment it makes sense for things that were plentiful two years ago to be plentiful again. But what if there is another inflation wave to come on top of these two? Wages could keep rising perhaps – pay demands are contagious.
But there is also a demand boom hiding in plain sight. The quantitative easing that followed the Global Financial Crisis didn’t lead to consumer inflation for the simple reason that it was mostly offset by banks repairing their balance sheets, so they weren’t lending much.
But this time around we have seen record-breaking surges in broad money supply: worldwide bank deposits rose 11.9% in 2020. As caution recedes, that money will probably be spent – and prices will rise. That may of course be a transitory effect as well – but too many transitory effects in a row and we will have to change the definition of the word transitory.
The inflation tax is one of the toughest for investors to deal with. It enhances the wealth tax elements of inheritance tax and capital gains tax – even if you make no real gains, you are still taxed on your nominal gains, something that obviously reduces real wealth. You should use your Isas and Sipps as much as you can.
Inflation will hit markets – here’s what to do
But it also hits bond markets hard – a huge worry for older people who have been “lifestyled” into seemingly low-risk bonds funds. UK gilt yields are at their highest since mid-2019 and ten-year Treasury yields are up too (prices go down when yields go up).
Worse for the complacent, it could have a nasty effect on the growth stocks that have been driving global markets – note that the US Nasdaq tech stock index is down about 6% in the last four weeks.
That’s a problem given that most equity investors seem to prefer growth stocks to anything hinting at value.
This week the eToro trading group reported that nine of the ten the top stocks held on its platform are growth stocks – Tesla and Nio being the top two. Meanwhile, funds network group Calastone said that September was the second worst month on record for UK equity funds in terms of flows, after June 2020 – when everything was being sold down.
While pretty much every other geographical region saw money flowing in, the UK saw a net £567m leave. If inflation gets to and sticks at, say, 4%, the prices of growth stocks will surely tank – you will want a 4% earnings yield to compensate for the inflation, something that suggests you won’t want to pay a price/earnings ratio of much more than 20-25 times for any equities. The p/e of the S&P 500 is currently 30 times; that of the FTSE 100 is more like 15 times.
That rather suggests that if you want to avoid the worst of the inflation effect it’s time to shift from growth to value, something the clever private equity industry is already doing. There’s a reason buyout groups have paid an average premium of 47% over the prevailing share price for UK companies this year.
Merryn discusses all of this and more with James Ferguson in the latest MoneyWeek podcast. Listen to the whole episode here.
• This article was first published in the Financial Times
