Paying for the pandemic

Our senior European economist, Hetal Mehta, looks at the implications of the UK government’s rising debt burden.

Courtesy of Chancellor Rishi Sunak’s latest spending review, we now have a better idea of the cost of keeping the UK economy afloat during the global pandemic. At an estimated £400 billion[1] for the financial year to March 2021, the UK’s debt stands at its highest level since World War II.

Should that worry us? In the short term, no. We believe any extra cash from the government to help prevent further economic damage caused by COVID-19 is not only necessary but healthy – if targeted in the right way.

The key aim is to stem a sharp rise in unemployment which would have long-term, damaging effects on the economy. At its peak, we believe the UK unemployment rate could reach 8%[2] (as opposed to just over 4% pre-pandemic).

Eventually, however, we’re going to have to pay for this pandemic. Methods at the government’s disposal could include an increase in taxes or cutting back on government spending. But, while rumours are circling as to which groups of individuals and businesses might be targeted, the exact mix of measures is hard to know.

We believe cutting back on government spending tends to be more effective at reducing debt levels than increasing taxes on individuals. After all, raising personal taxes tends to result in workers losing the incentive to produce goods and services efficiently.

But apart from debt-reduction measures, it’s also worth remembering that the level of debt will fall naturally as economic activity starts to pick up again and an effective vaccine is introduced.

Will a return to ‘normality’ then mean a pick-up in inflation? (Inflation refers to the general rise in the prices of goods and services such as food, clothing and transport). For the short term, inflation should remain low on account of schemes such as ‘eat out to help out’ which have kept restaurant prices artificially depressed. But once these schemes come to an end, we believe inflation could rise to around 2% in the spring of 2021.

Over the medium term, however, rising unemployment and increased competition on the High Street as more attempts are made to lure buyers into shops may mean that inflation is kept subdued. This is just one more reason why we believe the chancellor is going to have to keep interest rates low as he steers the economy back to health.

What does all this mean for investors in government debt? (Remember, a government bond is effectively an IOU for which the lender receives a fixed amount of interest from the government over a period of time). Currently, the government’s supply of new debt is being bought by the Bank of England. If this balance remains in place it’s hard to see the prices of government bonds falling significantly. Longer term, the current low interest-rate environment may also favour government bonds. If the Bank of England decides to cut interest rates even further (which is perfectly possible) that too could prove supportive for government bonds.

Remember, the value of any investment is not guaranteed. The value of investments and any income received from can go down as well as up and you may not get back as much as you had originally invested.

There is no guarantee that any forecasts made will come to pass.

 

[1] Source: FT as at 25 November 2020.

[2] Source: LGIM estimate as at November 2020.

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