With a week to go until the result of the 2010 General Election, all the political parties are still too scared to tell the electorate the harsh truth of just how much pain the winner of this year’s election is going to have to administer.

Whilst there is agreement that the size of the structural budget deficit is somewhere in the order of £70 bln to £80 bln, there has been no real attempt by any of the parties to explain just how hard it is going to be to fill in this particular hole, let alone how long it is going to take.

Annual UK GDP is currently in the region of 1.4 trillion pounds and the total amount the UK government expects to have raised in taxes in 2009/10 is approximately £400 billion whilst the government spent £573 bln in 2009/10.

Hence the truth (which the political parties are currently failing to tell the electorate) is that even after the economy fully recovers there will have to be a combination of tax increases, spending cuts and further economic growth which will all have to add up to £75 billion before the country gets back onto an even keel.

Put another way, either government spending will have to be cut by a total of 13% in coming years or total taxes will have to rise by 16% in future years (or more likely a combination of the two).  If you take into account that the NHS budget of £110 bln has been ring-fenced, then the spending cuts to be suffered by other departments will be correspondingly greater.

No party has mentioned VAT.  A rise in VAT from 17.5% to 20% would raise about £13 billion annually.  Expect VAT to be part of any forthcoming tax rise.

After the 2010 General Election, the UK is going to embark on a long, slow path to return its finances to order.  Anyone not expecting this to hurt them in their pocket is deluding themselves.  Stockmarket investors should continue to steer well clear of retailers and approach pub & restaurant stocks with caution.

The UK’s budget deficit is a very deep hole indeed and it is going to take a very determined politician a long, long time to get the UK back to a balanced budget.  The borrowing requirement for 2009/10 is around £175 bln and next year (2010/11) it is forecast to be roughly the same at £180 bln. 

Take a quick look at the following HMRC table which shows all the money raised in taxes, etc. by the UK government in recent years.  In the best year ever (2007/8) a total of £451 bln was raised.  The recession has taken its toll and total revenues in 2009/10 are forecast to be £397 bln.

The most recent figures published by the Office for National Statistics show UK government current expenditure was £564 bln in 2008/9.

The difference between what the government spends and what it raises in taxes is just enormous.  And the difference is not simply the money spent on bailing out the UK banking system because these statistics exclude the money spent on financial sector interventions (deemed to be temporary spending).

Lets assume that the economy recovers and in a few years’ time HMRC tax revenues bounce back to their all-time high of £451 bln.  Also assume that all those people who lost their jobs in the recession find employment again and therefore subtract the £32 bln rise in social security benefits & tax credits since 2004/5 (i.e. well before the recession started) from the £564 bln the government spent in 2008/9.  This is how the deficit is halved by doing nothing except praying for a full economic recovery.  However it still leaves the UK with a structural budget deficit in the region of £80 bln.

This is not meant to be a political blog but sometimes politics impacts upon the economy and the markets.  This structural budget deficit of £80 bln is what needs to be tackled by the next government which is elected in May 2010.  Sadly no mainstream political party seems to be brave enough to spell out the size of the hole the UK is now in for fear that the electorate will be too afraid to elect them.  Whilst carrying on as before will appeal to the electorate because they think that way they will not get hurt, it is really not an option.

A future government will have to go further than the pay freeze for the highest paid public sector employees which Gordon Brown announced this week. However a problem with imposing public sector pay cuts is that for every pound the government cuts pay, it loses up to 40 pence in income tax revenue and the economy also suffers because the other 60 pence is not spent on goods & services anymore (with knock-on reductions in VAT collections, etc.).

The UK’s structural budget deficit is not entirely due to Gordon Brown’s tax & spend policies, but had he saved a bit when the going was good (instead of “investing in public services”) then we wouldn’t be in quite such a horrible mess today. 

However this £80 bln hole is what the 2010 election debate should be about - pace Bill Clinton, ”It’s the budget deficit, stupid”.

The key issue for the markets to contend with in 2010 is the risk that the economy slips back into recession (the so-called “double-dip”).  As the banks have now been largely fixed, should the economy double-dip then it is likely the retailers will be foremost amongst the suffers.   

The retail sector had a strong rally last year as the stockmarket discounted a recovery.  If we use MKS as a proxy for the sector, they rallied from just above 200p in Dec 2008 to finish at the 400p mark, with the annual dividend cut to 15 pence along the way.  The risk now is that the consumer gets squeezed after the May election and consumer spending suffers as a result.  Even if consumer spending does manage to hold up, the sector has already priced in a recovery and there is not enough upside left to reward investors sufficiently to risk owning the shares.  If the sector continues to trade lower then at some point it will make sense to buy back in for the next recovery trade.

A second sector to be very careful of in 2010 is the pub & restaurant sector.  Wet-led tenanted operators such as ETP and PUB are going to continue to struggle whilst their food-led competitors MAB and MARS may fare relatively better.

It is likely that a newly elected government will both cut spending and signal tax rises once the economy is strong enough to bear them. The Government has a massive hole to fill in, net borrowing will end up somewhere around £175 bln in 2009/10 and £180 bln is forecast for 2010/11.  The fact that this is 12.5% of GDP does not tell the whole story as it also represents 39% of pre-credit crunch tax receipts.  The government’s income has fallen by 12% over the past two years but spending has yet to be cut by a single penny.  The emperor has no clothes – Gordon Brown will not countenance spending cuts and doesn’t have any money to “invest in services”, whilst the best David Cameron will be able to do is maintain spending on the NHS and cut spending significantly everywhere else. 

Take a minute to think about the mountain that needs to be climbed in the UK.  Central government total tax income is forecast to be £397 bln in 2009/10.  Adding on £175 bln net borrowing implies total government spending of £572 bln.  In the best year ever, total taxes raised were £451 bln (2007/8).  Its going to be a long, hard slog to get back onto an even keel and it will take years to fill in this particular hole via a combination of spending cuts, tax rises and hopefully renewed economic growth causing the tax base to grow as well.  The Bank of England will wait a very, very long time before risking any rate rises against this backdrop – it is more likely that QE will be resumed (from its current £200 bln) to support the economy/gilts market before any QE exit strategies are implemented.

At the moment the retail sector carries all the risk of being first in the firing line should consumer spending weaken and lead the wider economy into a double-dip recession.  Avoid retailers until the sector offers patient long-term investors a much better risk/reward.

UK politicians have started the new year with their eyes firmly focused on the upcoming General Election, which will most probably be held in May.  This week’s Hoon-Hewitt challenge on Gordon Brown’s leadership has only served to increase the uncertainty surrounding the result of the General Election.

Markets hate nothing more than uncertainty and although the Conservatives are tipped to win this year’s election there is the distinct possibility of the result being a hung parliament.  In such an eventuality the correct course of action for David Cameron would be to call another immediate snap election, seeking a clear mandate from the British public.  However, politicians enter politics in order to gain power so do not expect him to risk losing his grip on power (however slender) by risking another election.  The only upside of a hung parliament would be that the very competent Vince Cable would become a Cabinet minister.

What the Gilts market (in particular) needs from this election is a clear mandate for one party to go ahead and tackle the UK budget deficit in a decisive manner for the duration of the next parliament.  With 10-year Gilts now yielding 4% and Base Rates stuck at 0.5% until at least the other side of a post-election budget (and likely a lot longer if spending cuts & tax rises are sketched out in the post-election budget – as they should be), a sharp sell-off in the Gilts market ahead of the election is not likely so the pressure will be felt most in the currency markets.  Sterling depreciating will be beneficial to the stock market as a result of translating overseas earnings and a lower currency making UK assets cheaper to foreign buyers (retailers who source their product from overseas, as well as relying on UK consumers who will likely be squeezed by a post-election budget, would miss out on this particular party).

Uncertainties about an indecisive hung parliament are likely to surface first in the currency markets and we can expect Sterling to wobble seriously ahead of the General Election.  The Bank of England is unlikely to worry too much about a further slide in Sterling unless it becomes disorderly (as the UK economy, which is still officially in recession, will benefit from cheaper Sterling), so expect parity to be tested against the Euro, although it is doubtful Sterling will stay below parity for very long.