At the time of writing, and fully eighteen days after the General Election, we finally have some public assurance that the UK will have – for a time – a functioning government. The Conservative & Unionist Party, and the Democratic Unionist Party have announced a deal that will see the Northern Ireland MPs provide votes to the Government, in return for some fairly hefty financial support for the region and a commitment to maintain the triple lock on pensions and do away with means testing of the winter fuel allowance. Which provides more proof, if it were needed, that democracy and economic logic are, more often than not, uneasy bedfellows.
Writing with an element of perspective after the election, it appears to us that – despite our initial instinctive reaction of “here we go again” – the UK political situation may prove more durable than logic might dictate, and that a relatively hamstrung Conservative government might deliver a more beneficial type of Brexit. Coalition governments may be rare in the UK, but they are the norm in many other developed parts of the world. For different reasons, the parties in the current confidence and supply agreement are united in their desire to keep Jeremy Corbyn out of No10 Downing St. Regarding Brexit, those looking for a soft and business friendly type of departure are suddenly shouting the loudest. The dogma of a hard exit from the EU has been replaced by the Realpolitik of requiring votes from newly elected MPs in Scotland who’s constituents had bigger fish to fry than the EU exit, and the stark reality of losing seats like Canterbury and Kensington & Chelsea. The irony of the Tory repositioning to hard Brexit and hard immigration limits was that it lost swathes of support in its core, cosmopolitan seats, but did not pick up enough disaffected voters elsewhere to eat into the Labour heartlands. Expecting UKIP voters to drive a pincer movement on Labour backfired spectacularly.
It is not our place to over-analyse the political landscape. We do have to try and make sense of the economic landscape. Regarding Brexit, the full gamut of outcomes are still on the table – from an ultra-hard “No Deal” exit to no exit at all. The reality will be somewhere in between, but at this stage there is no point in us trying to second guess where that point might be.
Where there is perhaps slightly more clarity is that the political mood music has definitely swung towards ending “the Age of Austerity”. Particularly in crucial public sector services, there is a growing consensus that both wages and investment need to rise. The million dollar question is how does it get paid for?
The target for balancing the central government budget has been put back again, into the middle of the next decade, which will offer some loosening of the purse strings; but not nearly enough. Let’s be clear: taxation receipts will have to rise. Investment orthodoxy would have us believe that a rising tax take is likely to be bad for equities, but economies need healthy and educated populations, as well as crucial infrastructure. An increased tax take is not a bad thing for economic growth if it is put to productive use. Of more pertinence for us as equity analysts is how the tax is taken and what the ramification of these changes are in terms of long term behavioural shifts.
Part of the reason that government finances have not recovered as well in this economic cycle as they have in past cycles is that since 2010 the government has dramatically reduced the income tax base of the country. The means by which this has been achieved is by increasing the personal income tax allowance (which is currently £11,500), taking 4 million people out of paying income tax altogether. With a much narrower tax base, the impact of every penny rise in the tax rate is diminished, meaning that tax increases need to be more substantial, or directed heavily at certain portions of the economy. This has the capacity to bring material distortions to behaviour and in the generation of tax receipts themselves. As an investor in UK equities, there are two particular distortions that we need to be wary of. One potential distortion, and one that is playing out in front of us already.
Conversations with a number of housebuilders in recent weeks has highlighted the unintended consequences of using fiscal policy to address social problems, and when the weight of tax raising efforts falls on too few shoulders. There have been two major regulatory changes to the government’s relationship with the housing market over the last few years. At the bottom end of the market, the introduction of the Help to Buy scheme was designed to improve access to housing for those getting on to the bottom of the housing market, and to stimulate new housebuilding construction to address the country’s chronic shortage of housing stock. A laudable aim. At the other end of the spectrum, Stamp Duty changes were designed to stop foreign capital coming into the UK and further distorting an already tight housing market. It also had the impact of materially shifting the onus on raising taxation from this source from across the housing market towards the very top end of transaction values. A £1.5m house in England now attracts £93,750 in Stamp Duty on its purchase. In Scotland, the position is even more extreme – that same property would attract a tax of £138,350. In Scotland, a £750,000 housing transaction will cost almost £50,000 in land and buildings tax. These numbers may sound like a very rarefied atmosphere to some. However, particularly in the South of England, properties of this nature make up a substantial part of the housing stock. These rates of taxation are a clear inhibitor on activity, and it is no surprise that the overall tax take is nowhere near as high as expected. This is particularly the case in Scotland. At the same time, at the bottom end of the market, the support given to first time housebuyers through Help to Buy is allowing many to jump further up the property market ladder than they might have otherwise done. Rather than starting with a two bedroom apartment or semi-detached, many are making that first purchase into a three bedroom detached house, thereby eliminating the need for one or two moves over the coming decade or so as families grow.
Both of these trends are dampening activity across the spectrum of housing transactions, and the market in the middle is dependent on demand coming up and equity trickling down from the top and bottom ends of the market respectively. The health of the UK economy is normally dependent on a functioning housing market. We may be at the point where less intervention is more valuable for raising taxation revenues.
The experience in the housing market has warning signs for politicians to avoid getting other parts of its taxation policy very wrong. Whilst the Conservative Party has been predictably coy about where increased taxation will come from, there appears to be a swing in zeitgeist towards the Labour Party’s more overt “Eat the Rich” approach. This is incredibly dangerous. The top 1% of tax payers already account for 27% of the income tax take. This is exactly the cohort of tax payers who are in a position to alter their behaviour if they perceive it to be in their interest. They may stop making investments, they may look for ways to shelter income, they may retire and stop earning at all, they may move offshore. A taxation system has to be seen to be “fair” by all those paying into it. Democracy has an unfortunate capacity for the masses to victimise the few. In this case, the few don’t necessarily have to stand and take it, which would be to the detriment of everyone. To make matters worse, so much of this income tax comes from a financial services sector that’s future health is materially compromised by a hard exit from the European Union.
None of this is designed to try and make a political point. Quite the contrary – this is to highlight that whilst markets have largely shrugged their shoulders and got on with life in the post General Election world, there is still a substantial risk that politicians of all hues get in the way of economic stability. Markets feel serene. However, that should not glide into complacency. We strongly believe in the value creation capacity of the companies we have invested in. We equally believe that the UK still has the capacity to surprise on the upside in terms of its growth trajectory and for that to be reflected in the valuation ascribed to domestic profits going forward. The risks to that scenario are almost exclusively political in nature.
The General Election was supposed to bring certainty and stability to the political landscape. It has done the opposite.