Markets wait nervously for spending review

19th October 2010

Markets have certainly been taking the new government's tough stance on public expenditure to heart, especially the cuts as indicated in the incoming coalition's emergency budget.

As Keith Wade, chief economist at Schroders says in an interview with MindfulMoney: "Markets certainly rallied on the back of that emergency budget, with ratings agencies mostly reiterating their triple A ratings for the UK. So quite a lot of pricing in has taken place in relation to the promised tightening."

Wade's colleague at Schroders, European economist Azad Zangana, says the market appears to be in "contempt"  in the run-up to the CSR, adding: "Though we expect some of the tightening to be postponed, as long as the Chancellor sticks to his target of cutting the budget deficit to 2.1% of GDP by 2014-15, then there should be little reaction from the market. If anything, the market has been positive on Gilts lately."

Zangana says the spread on 10-year gilt yields versus 10-year Bunds is currently 59 basis points, its lowest level so far this year, and a substantial improvement from its peak of 103 basis points on 7/5/2010.

"However, though there has been a general improvement in sentiment towards gilts, it helps to have the Bank of England standing by threatening to hoover up billions more out of the market."

There is no doubt George Osborne is planning a massive tightening in public spending, which Wade estimates could amount to an eye-watering 8% of GDP per annum, even if spread over four or five years.  

While rating agencies have generally given the Chancellor the thumbs up so far on the assumption he can deliver the cuts he has promised, some have concerns. 

Standard & Poor's for instance has kept its triple A rating on the UK but has the country on ‘negative watch', meaning it is not sure yet whether the government can deliver fully on the cuts.  

So far, we have been told Chancellor George Osborne plans to eliminate the structural deficit – the part of the deficit that will exist even when the economy has fully recovered – by 2015-16.

To do that, as the BBC explains, Osborne needs to ‘repair' the budget to the tune of £113 billion by 2014-2015. The indications are he intends around £83 billion of spending cuts and £29 billion worth of tax rises by that year.  

The Institute for Fiscal Studies (IFS) has adjusted these figures and expressed them in today's money. On that basis the spending cuts would total £68bn and the tax rises £24 billion.

We already know that defence is going to suffer the biggest cuts since the end of the Cold War, with a hefty 8% reduction in its £37 billion budget on the cards. Some areas, such as the National Health Service and overseas aid, will be fully protected.

In education, universities will be the major target, with the Guardian reckoning higher education, science and research budgets could lose between £4 billion to £5 billion, out of a current allocation of about £11.5 billion.

Beyond that, all other departments, including transport and the environment, have been told to prepare for cuts of between 25% and 40%. It has already been announced that 192 quangos are to be axed.

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