Do you agree with the consensus that tax rises in the Budget are inevitable?
It doesn’t have to be that way, but it probably will be. Rachel Reeves has set herself a fiscal rule to balance the budget by 2029-30, but borrowing costs have gone up. The Government has not trimmed spending as much as it said it would, and the economy is forecast to be a bit weaker. If the Chancellor does nothing, she will break her own rule. Now she could do that, but the financial markets will react badly. Borrowing costs would increase, putting her in an even trickier position. She could cut spending of course, but her fellow Labour MPs won’t let that happen. This leaves a third, least-worst option – raising taxes, which I think she will do.
What sort of taxes do you think the Chancellor will raise?
Based on our estimates, the Chancellor needs to raise between £20-30 billion – and there is a lot of speculation about what kinds of tax rises might come. Businesses were hit last time, so I think households will do the heavy lifting this time around. The Chancellor also wants to bring inflation down, so I doubt there will be tax increases that would raise inflation, such as VAT. This means that people at the higher end of the income scale will be targeted. There has been talk of increasing income taxes for high-income earners and possibly introducing a property tax, or a mansion tax, on expensive properties. But the Chancellor needs to get a balance between lowering inflation and not weakening the economy too much. She will have to think very carefully about which taxes she raises to get that balance right.
Watch the full recording:
Is there scope to refresh the budget numbers to prevent tax rises?
There is some scope. Gilt yields have fallen quite sharply recently, which lowers the government’s borrowing costs. The Office for Budget Responsibility provides the economic forecast – and there is some debate over whether it will take those yield falls into account. This wouldn’t typically be the case, as the forecasting window would have shut weeks ago. The bigger question is whether she should be wary of the financial markets. The Chancellor is in a different position than her predecessor was five years ago. With interest rates at 4%, markets are a bit more on edge, and there is less leeway to ignore lenders. Politically and economically, she will not want to repeat Liz Truss’s 2022 Mini-Budget.
Assuming tax rises go ahead, what will the effect be on inflation?
We are moving towards a situation where the UK’s inflation outlook will be much better. I think we are at the peak now (at 3.8%). That doesn’t mean inflation is going to fall like a stone; I suspect it will be around 3.5 to 4% for the next three or four months. Energy prices are set to fall slightly and we have a very weak labour market. This means wage growth is likely to slow over the next 6 to 12 months, so businesses won’t need to raise prices as much. I think inflation will surprise – it may even return to the 2% target by the end of next year for the first time in about 4.5 years.
What will happen to interest rates?
If we are correct and inflation falls, it gives the Bank of England the green light to continue to cut interest rates. I don’t think they will cut rates immediately, though. It might cut rates in December, but I expect it will still be worried about the inflation outlook. It will become clearer early next year and I expect the Bank will then be in a position to reduce interest rates to about 3%.
What is your outlook for the UK economy?
Growth isn’t terribly weak, but it’s not terribly strong either. Our forecast is for growth of 1.2% next year, but that is before we consider any tax rises in the Budget. It could then be trimmed to around 1%. If we are correct, the outlook for the UK economy going into 2027 will look brighter. We are expecting an acceleration of growth to 1.5%, so you would be sailing along at a nice rate of knots for an economy like the UK.
What are your thoughts on the US? The economic picture looks mixed and yet share prices are hitting new highs.
The American stock market is starting to look a bit frothy and it feels like we are entering bubble territory. Earnings and expected earnings have been the main fuel, suggesting it might have a bit longer to run. But equally, it feels as though a bubble is forming – and all bubbles in equity markets tend to burst at some point. Trying to forecast when that will happen is impossible. We have pencilled in a correction for 2027, but it is just to signal that we think there will be some reckoning at some point. We certainly believe we are closer to the end of the AI-fuelled rally in equity prices than we are to the beginning.
Could that have knock-in effects on the wider economy?
To answer that question, you have to go compare the Dotcom crash of early 2000 with the Global Financial Crisis (GFC) of 2008. The former didn’t really hurt economies, whereas the crisis was fuelled by debt, causing widespread recessions and higher unemployment. When you consider AI-related investments have driven the stock market, it’s not associated with big increases in debt or leverage. So even if there is a correction, I don’t believe the implications for the economy will be as grave as some might expect.
The Weatherbys view
While it’s true that AI has helped US stock markets reach new highs, and that share price valuations are relatively high, we don’t think that this necessarily portends a reckoning.
Firstly, even though there will likely be a fair few venture capitalists who end up nursing losses from speculative AI bets, the chief protagonists can point to very substantial profits and have balance sheets in robust health – in stark contrast to the Dotcom era.
Secondly, valuations have no causal power – stock markets do not decline because of them. There has to be a reason for asset prices to decline. In 2000, it was the run of six aggressive interest rate cuts by the Federal Reserve, for instance. In hindsight, we see that high valuations were followed by a stock market decline – but how could it have been any other way? This seems to confuse correlation with causation.
Thirdly, we don’t see anything like the “irrational exuberance” that characterized the run-up in internet companies in the late 1990s. Then, share price multiples reached completely outlandish levels, as markets climbed almost non-stop. But only back in April we saw the S&P 500 fall by 10% in two days in response to the unveiling of tariffs. Investors hardly seem blasé about risk – if anything, markets cognoscenti seem to talk of little else apart from comparisons with the Dotcom bubble. We are still in the long psychological scar of that episode, which acts as both inoculation against similar over-excitement as well as a spectre seen in every shadow.
That doesn’t mean we think shares are risk-free, of course. The future is profoundly unknowable, and shocks by definition come out of nowhere. But we argue that the best preparation for volatility is a sound financial plan, ensuring you can weather financial storms comfortable in the knowledge that no evasive – potentially damaging – action need be taken.
After all, markets have always recovered in the past, rewarding disciplined investors. More money has likely been forfeit trying to predict market crashes that arrive years down the line than has been saved in successfully dodging them.
What you need to know
Capital Economics is an independent consultancy firm. Past performance is not a guide to future returns. Please note that the value of investments can go down as well as up, and you may get back less than you originally invested.