Budget commentary

As opinion polls have narrowed, the high-stakes political poker game of the UK election has begun to dominate investor thinking, especially in the bond markets and sterling. The pressures on public sector finances have been discussed constantly in the media since last November's
Pre-Budget Report. However, many important decisions have been postponed and markets await the election result, which could act as a catalyst for significant policy change.

The latest Budget highlighted these issues. Although the Chancellor was able to welcome the end to the long and deep UK recession, the detail of his Budget report revealed the true burden of this severe downturn coming on top of the previous public sector deficits. On the Treasury's forecasts, the level of UK debt is set to soar from £776 billion in 2009/10 to £1.4 trillion in 2014 - equivalent to about three quarters of national income. Many independent commentators fear that the outcome could be worse as the government is assuming economic growth can reach 3.0-3.5% a year, well above the long-term trend and external forecasts.
 
Debt levels matter because of the cost of servicing that debt. Next year the annual interest bill will reach £43bn, rising to £63bn within five years, assuming an annual average interest rate of 4.5%. Clearly, the outcome would be even more should government bond yields head sharply higher. Putting that sum into context, £63bn compares to £70bn expected to be raised from VAT in 2009-10, or total spending that year on the NHS of £100bn, or the combined expenditure of some £60bn on the defence budget plus the business, innovation and skills department.

There was little immediate reaction to the Budget announcement by investors in the bond, equity or sterling markets. This was partly because investors have had a long lead time to consider all these issues. They have already faced an increasing calendar of large gilt auctions, further depreciation of sterling against its major trading partners, worries about a hung parliament and most recently worries about whether the UK could lose its 'AAA' sovereign credit rating.

Gilts have sold off steadily since last autumn, pricing in a lot of bad news. It is clear that major changes still need to be made on spending and taxes to put the deficit onto a credible glide path back towards a sustainable situation. That is why there was little reaction to the Budget statement - big decisions will be made after the general election, when the Chancellor has to reassure domestic and international investors with detailed plans to lower the debt burden. Failure to convince investors could lead to even more volatile markets ahead.