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April 29, 2010

In a Bond Bind

By Spear's

How will a Lib-Lab coalition government affect the UK’s chances of funding all its debt? Freddy Barker investigates

How will a Lib-Lab coalition government affect the UK’s chances of funding all its debt? Freddy Barker investigates

You may think that Gordon Brown is having a rough week. He’s just been caught bad-mouthing a voter and, in the ultimate act of political grovelling, he went to her house to apologise. (Why is that we can have opinions on our politicians but they can’t judge us?)

The reality is, however, that David Cameron is the one choking on his breakfast cereal this morning. For the latest YouGov poll shows his lead dropping like a stone. From 17 points in October 2009 to 12 points in January 2010 to 7 points today.

The collapse is doubly painful given the difficulty of Cameron’s task. To take Downing Street on 6 May, his party must win 117 seats. That’s a swing of 6.9 per cent. The second biggest in history. Smaller only than the 10.2% demolition job that Tony Blair inflicted on John Major in 1997.

Some say however that the polls are wrong. After all they have a history of underestimating left wing defections – think 1970. And they are increasingly volatile. Unknown unknowns – such as Clegg soaring eight points overnight are one thing, John Prescott punching voters is another. But the maths all points in one direction.

‘If you translate the latest polls into share of votes, we will see a hung parliament on 7 May with Labour holding the largest number of seats,’ says Joe Twyman, Director of Political Research at YouGov.

So what might this mean for the country’s finances?

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The first task for re-elected PM Gordon Brown, according to Keith Wade, chief economist at Schroders, would be to decide between a minority government or a formal coalition with the Liberals. Clegg and Cable’s popularity should however force his hand on this matter.

The forecasted Lib-Lab alliance would then work together from 7-25 May to devise a new programme. (The Queen’s Speech is on 25 May.) They will do this under the glare of the markets, who will be looking for clear signs of action on the UK’s astronomical deficit, which hit £167,981,000,000 in 2009.

To defuse the debt bomb, the coalition will need to do some hard thinking, however, as Labour haven’t produced a credible plan thus far. To date, they have announced a deficit cut from £166.5bn to £74bn by 2015 (that’s a cut of how much debt we take on every year, not a cut in the debt; similar to an alcoholic saying that he’ll be clean by 2015 by drinking 4½ pints a day rather than the usual 10). But of the aforementioned £92.5bn decrease, only £48.5bn has so far been identified. This leaves a whopping £44bn black hole.

Where will the money come from?

It’s a tough question – equivalent to asking someone to magic Roman Abramovich’s entire fortune out of the blue, six times over.

The quickest way for the Lab-Lib pact to fill the void would be through VAT. Azad Zangana, European economist at Schroders, predicts that the government will hike the regressive tax rate to 19% by Jan 2011. He argues that the £8bn revenue that this would raise is the exact sum that Labour has targeted from tax rises by 2014.

The other alternative is a capital gains tax hike. Amazingly, CGT accounts for just 0.6% of HMRC’s current tax take. To put that in perspective, the Revenue receive 3.5 times as much from tobacco duties and 10 times as much from fuel charges.

St Vince of Cable has latched on to this disparity. In a savage attack on HNWs, he has laid out plans to level capital gains with income taxes. Add this to the mansion tax and all we’ll ever read about in the new decade is the Laffer curve.

How will the markets react to these developments? 

As ever, the bond market is key. James Carville, Bill Clinton’s economic advisor’s joke about wanting to be reincarnated as the fixed-income market, so that he could intimidate everyone, remains as pertinent as ever.

If they have an opinion, the markets are hiding it behind a poker face. As Richard Buxton, head of UK equities at Schroders, said: ‘Thus far, the market has completely ignored the General Election; it’s just focused entirely on what’s going on in Greece and on what is going on in company profits.’

Schroders’ head of European and UK Interest Rate Strategies, David Scammell, agrees that yields will jump only if the markets are unconvinced by the coalition’s austerity plan. ‘If you look at the recent rise in Greek yields, you will see that the markets are in no mood to pander to governments who don’t protect their creditors,’ he says.

With £500bn of debt to raise over the next three years, it is still unclear whether global financiers will fund our excesses, especially since we’re asking for £170bn this year in upwards of 70 gilt auctions. ‘This is a very tall order,’ Scammell cautions, adding ominously that three to four years ago the government was borrowing £30-50bn per annum.

Scammell’s prediction should worry HNWs, for the main parties currently have no plan. They aren’t being honest about how they’re cutting. And they aren’t getting beyond the ‘early and aggressive’ or ‘later and less’ debate. For example, the proposed cuts are so similar, with only £8-10bn of difference in the per annum deficits by 2015/16, that it doesn’t make much difference who’s in No 10 come 7 May.

Let’s hope then that Brown and Clegg – if they are elected – are big enough to put their differences aside and present a radical proposal to the House and to the markets. It’s 25 May that HNWs should regard as D-Day, not 6 May.

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