George Osborne’s spending review has been front page news for the past few days and its effects will linger significantly longer, we asked one of our key fund management partners, Seven Investment Management (7IM) to give us their thoughts. This is what Peter Sleep, Senior Investment Analyst at 7IM had to say:

Journalists up and down the nation will be reaching for their copy of Roget’s Thesaurus to find new descriptions for the reductions contained in George Osborne’s Spending Review. More slashes than Bates’ Motel; more cuts than Wilkinson Sword; more red ink than my GCSE French paper…

The fun will be endless for the headline writers, but ultimately all are agreed that the present financial hole the government is unsustainable. The government spends seven Pounds for every five Pounds it raises in tax. Simply put, we spend too much on ourselves, which you may be able to see in the table below; the white block labelled “Public sector net borrowing” is the forecast deficit this year.

As an investor, you have a vested interest in seeing the budget balanced. If it is not, you may ultimately have to pay by suffering inflation and seeing the real value of your investments in gilts, bonds and cash wither away. Those on fixed incomes and pensions and those that have saved will pay for all the rest of the population.

The mild market reaction to the Spending Review, with Sterling and gilts flat and the stock market up in line with the international averages suggest that there were no real surprises in the spending review. (Something you may have gathered from the news headlines or the empty benches around George Osborne as he finished his speech.) If the markets had sniffed that the Coalition government were not trying to balance the budget, Sterling and gilts could have been down significantly.

Three levels of debate

The debate leading up to the Spending Review was at three levels. The first level was a debate conducted mainly among economists, about how quickly the cuts should be made. The second level was about the combination of tax rises and spending cuts. Finally the third, and most contentious level, is where the cuts should fall. Where the cuts should fall was the purpose of the Spending Review.

Let’s quickly deal with the first two levels of the debate: there is a school of thought that cutting government expenditure may undermine the fragile economic recovery. There is some reason for significant concern here, but the decision was made in the Coalition government’s first budget to cut sooner rather than later to prevent a Greek/Irish-type situation happening. As soon as the Conservative party was elected as the largest party in Parliament, we also had a pretty good idea that the deficit would be closed more by spending cuts rather than tax increases.

The most controversial cuts to spending were largely as trailed during the party conference season or leaked in the press. Overall government spending will be reduced by 19% in real terms by 2014-2015. It is estimated that this will reduce public sector employment by about 500,000 over the course of the next 4 to 5 years. Within this the government had previously promised to grow real growth in Health spending, International Development and the state basic pension.

Where will the spending cuts fall?

The spending cuts can be broken into three main parts – spending on day to day government (courts, defence, health, etc.), capital spending and “annual managed expenditure (AME)” or welfare-type cuts.

Firstly, spending on “departmental program and administration budgets”, that is the day to day spending of government, falls by 8.3% in real terms by 2014-15. Health has a small increase of 1.3% (in reality this is unlikely to be enough as we are all getting older and need more health care). Defence spending is cut by only 7.5% whereas most of the other great departments of state take cuts of around 25%.

The cuts fall disproportionately on the second area of spending, namely capital spending, that is on construction type work like the renovation of our schools. This is possibly why the impact on jobs is relatively large as it will fall on the labour intensive construction sector. Capital spending is forecast to fall by 29% cumulatively through to 2014-2015.

Finally, the “AME” measures are forecast to save about £11Bn by 2014/15. The biggest of these measures is the cut to child benefit for higher rate tax payers, saving £2.5Bn, not too closely followed by increased public sector employee pension contributions bringing in £1.8Bn.

The Coalition government hopes that by 2015-16 the huge deficit will be reduced by a combination of
spending cuts, tax increases (like the VAT increase next year we are all looking forward to) and private sector GDP growth as shown below in the chart. The chart is based on 5 year forecasts for growth and tax. Clearly if the economy does not grow we will remain in the same mess and we really will be looking down the barrel of a gun.

In terms of impact on your household it seems that those that are in the wealthier decile will bear the largest burden as they will pay more tax and receive less child benefit. Unfortunately, due to the regressive nature of some taxes like VAT, the poorest decile will also take a large hit from reduced benefits and higher tax.

Time to revisit your retirement plan?

In summary it does not seem that there were any real surprises in the Spending Review. Your cash savings are as safe, maybe safer, than they were this time last year, although the change in the retirement age may prompt you to review your saving plans with your Financial Adviser. It is possible that there will be French style riots in the streets, but this seems unlikely at present. More than probably we will have to listen to disaffected public sector workers complaining about “poor morale”; a very British way of protest.

The real crunch will come if the economy does not grow. Much of the fall in the deficit is forecast to come from higher tax revenues and lower benefits on the back of economic growth and higher employment. If the growth does not come through, the deficit reduction will not happen to the desired extent and then it will be a time to make some really hard choices along the lines of more cuts or higher inflation. That may be the time to plan in earnest for a retirement abroad.

Peter Sleep
Senior Investment Analyst
21 October 2010