Although real gross domestic product (GDP) growth – growth in the economy adjusted for inflation – has been weaker than expected, nominal GDP growth is way above OBR expectations. We expect the higher level of nominal GDP to underpin revenue projections in the years ahead, helping offset losses incurred due to quantitative tightening (the Bank of England has been selling the bonds it bought as part of its quantitative easing programme for less than it bought them for).  

Medium-term UK GDP and fiscal projections

Now that we have half of the 2023-24 financial year’s borrowing data, we can see the cumulative Central Government Net Cash Requirement (CGNCR – the amount of money the government needs to borrow every year to pay for public spending) stands at £87.1bn, £44bn above its level a year ago – but, more importantly for markets, £14bn below the OBR’s projection in the March 2023 Budget.

The main factor driving this undershoot has been higher-than-expected tax receipts buoyed by wage inflation (cumulative income tax receipts are up 11.9% year-on-year), higher nominal expenditure (VAT receipts are up 8.7% year-on-year) and elevated corporate profits (with the result that corporation tax receipts are up 20.5% year-on-year). Cumulative central government tax receipts are 5.6% higher than in the first six months of fiscal year 2022-23.

Growth: The nominal GDP forecast for fiscal year 2023-24 of 2.7% that the OBR made in the March 2023 Budget is substantially below our 8.0% expectation (which comprises three quarters of realised data). Although we don’t expect major revisions to the OBR’s nominal GDP growth forecasts for 2024 and beyond, the level of nominal GDP is likely to remain some way above what it expected in March. That said, we expect tax receipt projections to remain relatively buoyant, and some way above the March Budget projections.

Public finances: The UK’s fiscal position, however, remains constrained. The OBR noted that its March 2023 Budget projections showed the “smallest amount of headroom [0.2% of GDP, £6.5bn] any Chancellor has set aside against his primary fiscal target”. However, the undershoot in borrowing this year gives the government some near-term leeway.

For the remainder of the current financial year all the way through to the next general election, the key question for the gilt markets will be: how much of the undershoot in borrowing is likely to be recycled into higher public spending and / or tax cuts, and when?

There’s no shortage of demands on the public purse, but the government is likely to want to keep much of its fiscal powder dry until the 2024 spring Budget, closer to the next general election. That means we expect any sizeable pre-election tax cuts, which are a political imperative with the government trailing badly in the polls, to be held back until next year, and such an approach would also enable the government to adopt a message of “fiscal responsibility” in the short term.

Any fiscal policy loosening in the Autumn Statement is likely to centre on additional public spending – extra funding for the health service over the winter, school infrastructure spending and additional defence commitments. Overall, we expect a relatively modest net fiscal giveaway in the region of £4bn.

We expect the lower-than-expected CGNCR to result in a marginal shift in gilt issuance buckets, with relatively higher issuance in short- and medium-term gilts, which should support gilt yields in the immediate aftermath of the Autumn Statement.

The modest undershoot in borrowing this year does not change the broader narrative that gilt supply will have to remain heavy for years to come. In fact, gross bond issuance could be around 10% higher in fiscal year 2024-25 than in 2023-24.

Even though we expect bigger, and earlier, interest rate cuts in 2024 than the market is pricing in (100bps by the end of 2024, with cuts beginning in August), this supply outlook is likely to weigh on yields, especially given the backdrop of weak investor demand and structural shifts in the traditional buyers in the gilt market (liability-driven investors and overseas investors).

Taking the supply-demand imbalance into account, yields are likely to end 2023 higher than would be the case in a monetary policy vacuum. We still think the near-term fair value for 10-year gilt yields is 4.6% but believe they could end next year closer to 4% after rate cuts have begun.

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