Raising Revenue from Reforms to Pensions Taxation

Economic

Summary:

How should pensions tax relief be reformed, and could it be done in ways that raise revenue?

Recent weeks have seen speculation that the new Chancellor will make changes to pensions taxation to raise revenue in the upcoming inaugural Budget. The current system of pensions tax provides overly generous tax breaks to those with the biggest pensions, those with high retirement incomes and those receiving big employer pension contributions, and there is a strong case for reform. However, insufficient support for pension saving could risk inadequate accumulation of private retirement resources and greater reliance on the state. The taxation of pensions needs to be carefully designed.

Previous research at IFS, funded by the abrdn Financial Fairness Trust, has considered the design of pensions taxation in detail. Here we summarise some of the main options for reforming the tax treatment of private pension saving. We start with what we argue should not happen, before moving on to more desirable reforms.

Capping up-front income tax relief should be avoided

The most commonly suggested way to raise revenue from changes to pensions taxation involves reducing up-front relief from income tax.

Currently, pension contributions (up to an annual limit) attract income tax relief while pension income is taxed. This is a coherent approach. Earnings put into a pension are taxed once – at the time they are withdrawn from the pension.

One implication of this approach is that some people get up-front tax relief at the higher (or additional) rate of income tax but pay the basic rate of income tax on pension income. It is debatable whether this is a problem. By allowing people to smooth their taxable income over time, it creates a more equitable income tax treatment between people whose incomes are spread more or less evenly across years. But clearly some people think this system is unfair.

It may therefore be tempting to reduce up-front relief for higher-rate taxpayers. The sums at stake are large: limiting up-front relief to the basic rate of income tax would be a £15 billion a year tax rise, the vast majority of which would come from those who are in the top fifth of earners when making pension contributions. But it is worth noting that this reform would not only affect those who are higher-rate taxpayers under the current system: more people would be brought into higher-rate tax if their (and their employer’s) pension contributions were no longer excluded from tax. For example, an experienced nurse earning £45,000 would typically get an employer pension contribution that the government values at an additional 23.7% of salary – more than £10,000 a year. Given that valuation, about half of the pension contribution would fall into the higher-rate income tax band, leaving the nurse with an additional tax bill of about £1,000 a year if relief were restricted to the basic rate.

Tempting as it may be, there is no coherent logic to making relief on contributions flat-rate while continuing to tax pension income at the individual’s marginal rate.

The same logic that says it is ‘unfair’ for people to get higher-rate relief on contributions and pay only basic-rate tax on withdrawals would presumably imply that it is equally ‘unfair’ for people to get basic-rate relief on contributions and pay no tax on withdrawals if their income in retirement was below the personal allowance – yet that argument is never made. And restricting relief on contributions while leaving the taxation of pension income unchanged clearly would be unfair on those (few) who are higher-rate taxpayers both while in work and in retirement: they would in effect be taxed twice on the same income, creating a large penalty for saving in a pension.

The point of both these examples is that a coherent tax treatment of pensions must consider the treatment of pension contributions and the treatment of pension income together. If there is a case for relieving all pension contributions at the same rate, there would equally be a case for taxing all pension income at the same rate. And if the real aim of reform is simply to increase income tax on higher earners, then this should be done directly, through increases in income tax rates or cuts in income tax thresholds.

Principled arguments aside, moving away from up-front income tax relief at the taxpayer’s marginal rate would raise major practical challenges for defined benefit pensions as the value of employer contribution that should be assigned to each individual employee is not straightforward to measure. This is not a minor issue: HMRC estimates that almost half (46%) of all up-front income tax relief is attributable to defined benefit schemes. A reform that treated these schemes (many of them in the public sector) more favourably would be inequitable. There are more coherent and implementable ways to reform the system – including better ways to raise revenue from those with the highest income and wealth.

Pensions should be subject to inheritance tax

Unlike with housing wealth or other savings, if someone dies and passes on a pension pot to a non-spousal heir, the pension does not count as part of their estate for inheritance tax purposes. Ending this inequitable treatment could raise several hundred million pounds a year in the short term, rising quickly thereafter (potentially to as much as £2 billion a year, though probably less) as the introduction of ‘pension freedoms’ in 2015 means more and more people will be dying with pension wealth.

The 25% tax-free component should be targeted towards those with smaller pensions, not those with higher incomes

When withdrawn, 25% of a pension can be taken tax-free (up to a limit of 25% of £1,073,100, i.e. £268,275), with income tax payable on other withdrawals. This subsidy to pension saving has an estimated long-run annual cost of £5.5 billion, with 70% of the relief going to pensions accumulated by those in the top fifth of earners when making their contributions. This well-known part of the pensions landscape could have some justification if it encouraged saving on the part of those who would otherwise save too little. However, it is poorly targeted in two regards.

First, the 25% tax-free component subsidises further pension saving even for those who already have large pensions. While there is a case for encouraging people to save at least a certain amount for their retirement, it is hard to justify continuing to subsidise extra saving for individuals with pension wealth little short of £1,073,100.

The incentive should be removed from those with larger pensions. Reducing the amount that can be taken tax-free from £286,275 to £100,000, for example, would affect about one-in-five retirees (and almost half of those who had been employed in the public sector) but would mean about 40% of pension wealth lost the benefit of the tax-free component. Such a change would raise around £2 billion a year in the long run (40% of the long-run revenue yield from abolishing the tax-free component completely), with losses concentrated among the relatively wealthy.

Second, the 25% tax-free component provides a more generous subsidy for higher-rate taxpayers than for basic-rate taxpayers, and provides no subsidy at all for the part of pension income below the income tax personal allowance – that is, for those low-income pensioners whose pensions arguably most need boosting. A better alternative would give an equal top-up on all withdrawals from pensions. A top-up of 6.25% (before applying income tax), for example, would be equivalent to the 25% tax-free component for someone who is a basic-rate taxpayer in retirement. But such a change would mean a bigger subsidy than now for non-taxpaying pensioners and a reduction in the subsidy going to those paying the higher or additional rate of income tax in retirement. Overall, it would be a tax cut of around £1½ billion a year in the long run – although such a change could be implemented alongside a cap on the cumulative amount of pension income to which the top-up was applied, further reducing the subsidy for those with large pension pots and therefore the overall cost.

One complication with such a change is that it would (unless implemented over a generational time frame) involve some degree of retrospection: people could reasonably argue that they had saved on the understanding that they would be able to take 25% of their pension tax-free. A slower transition would temper that retrospection but would also need to be weighed against the ongoing costs of providing large tax subsidies for individuals with sizeable pension pots.

Reform the generous NICs treatment of employer pension contributions

Employer contributions to pensions are not subject to employer or employee National Insurance contributions (NICs). These subsidies to saving are generous, opaque and poorly targeted, and could be sensibly reformed – though Labour’s manifesto pledge not to increase NICs might make that difficult.

Different ways forward are required for employer and employee NICs. It would be sensible to move towards levying employer NICs on employer pension contributions. If levied at the full rate (13.8%), this would raise around £17 billion per year. We estimate that £14 billion of this rise relates to contributions for new pension accrual (as opposed to contributions plugging deficits in defined benefit schemes), with around £6 billion of that £14 billion coming from contributions made to pensions held by the top 10% of earners. A ‘big-bang’ change that completely eliminated this subsidy would risk a large decline in contributions to pensions. A more cautious approach could be taken where employer NICs are levied on employer pension contributions while a subsidy to employer contributions is introduced at a lower rate. For example, levying employer NICs (at the rate of 13.8%) alongside a new subsidy for employer pension contributions of 10% would mean a tax rise of around £4½ billion per year.

In the case of employee NICs, there is a good case for moving towards a system with up-front relief for employee, as well as employer, pension contributions. In return, employee NICs would be levied on private pension income. In the long term, such a change could raise substantial revenues (if pension funds’ investment returns are strong) and re-target financial incentives to save away from the top tenth of earners and towards those in the middle of the distribution. The transition to such a system would need to be carefully considered. If relief from employee NICs were given immediately for all new employee pension contributions, the annual cost would be around £2–3 billion. This initial outlay would be less than the £4½ billion that would be raised by replacing the existing employer NICs subsidy on employer pension contributions with a flat 10% subsidy. In addition, each percentage point of NICs levied on private pension income would raise around £¾ billion currently; but immediately charging full employee NICs on private pension income might be seen as unfair because current pensioners may have paid employee NICs on their employee contributions (implying some paying employee NICs twice) and many might have saved in the expectation that they would not face this tax in retirement. There is no perfect solution here, but one way forward might be to phase in NICs on pension income by date of birth, with later-born cohorts (more of whose pension contributions would have received NICs relief) paying higher rates of NICs on their pension income.

Stability is valuable

There are sensible reforms to the taxation of pensions which could refocus the support for pension saving towards those more at risk of undersaving. A package of reforms along the lines set out above could be designed in such a way as to raise revenue while ensuring that the bottom eight deciles of earners gain on average (in the long run) – and see their incentives to save in a pension strengthened. Comprehensive reform is preferable to reintroducing a lifetime limit on tax-privileged pension wealth (a change which Labour had pledged to make but dropped during the election campaign). There would be political choices to be made about how quickly to phase in some reforms.

Constant tinkering with pensions taxation is not welcome, though. Whatever package of reforms is pursued at the Budget, it is important to set out a clear and coherent direction of travel for pensions policy and, as far as possible, provide a predictable environment for savers. As the government undertakes its promised review of the pensions system, it should articulate how it sees tax fitting into an overall plan for state and private pensions.

To stay updated on all economic events of today, please check out our Economic calendar

Risk Warnings and Disclaimers

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Pepperstone

Economic

There was absolutely no ambiguity in the way the market traded the US jobs data - it was solid across all metrics, and remaining US recession calls have once again been pushed out. The more pertinent question is whether the consensus ‘soft landing’ thesis is at risk of becoming a ‘no landing’ scenario.

With the positive turn in the US economic data we saw throughout last week, US interest rate swaps price a more gradualist path to Fed easing, with a conviction 25bp cut expected in both the November and December FOMC meetings. However, with rate cuts still being the default position, and when married to upbeat earnings expectations and China going hard on liquidity and fiscal, the equity bull case and the USD get a shot in the arm.While geopolitical headlines and the possibility of an energy supply shock remain a continued threat to sentiment, those set long of risk haven’t heard anything significantly market moving through the weekend and head into the new trading week feeling pretty good about the prospect of further upside.

Can US economic exceptionalism be sustained?

The market has seen yet another case study where growing concerns around a sustained deterioration in the US data flow have collided with a series of better key economic data points (JOLTS, ISM Services and NFP). The result has been market players having to rapidly rethink exposures – notably in US Treasuries where yields have teared higher on the week. In turn, the US economic exceptionalism trade has made a comeback, and tactical traders question whether this theme could last into the November US Election, especially if Trump’s odds were to improve.

The Citigroup US economic surprise index has risen to the best levels since April (see chart above), highlighting the trend of US data releases beating economists’ consensus expectations. We can also see the US economic surprise index having the strongest positive trend relative to other major nations' economic surprise indices, and while not yet at levels which really cement a consensus US exceptionalism/long USD position trade, it is certainly adding to the current upside momentum.

US Treasuries driving USD flows

US 2-year Treasuries aligned with the moves in the US surprise index, closing the week with a gain up a sizeable 36bp w/w, with yields eyeing a retest of the 4% level, driven by Fed rate cuts massaged out of the US rates curve. The USD responded hard, having its best week since Sept 2022, with the DXY (USD Index) closing higher on each consecutive day last week. On a broader basis, the USD gained ground vs all G10 currencies, notably vs the JPY, aided by calls that the BoJ (and new PM Ishiba) may be making a policy mistake by flipping to a more dovish stance and backing away from further hikes.

There has been a focus on relative fiscal trends too, with France set to announce its budget as it starts its proposed staggered journey to a 3% deficit of GDP by 2029. A more austere fiscal program in France, Italy, and Spain, will pale in comparison to ever-increasing debt levels in the US, and over time this could prove to be another factor that drives EURUSD lower.

US Economic Exceptionalism Makes a Comeback_3

Importantly for the USD, we see US Treasury yields rising sharply on a relative basis to the G10 peers, where yield differentials have been a key factor driving the USD outperformance. Should the US Treasury yield premium continue to increase vs other developed market bonds (e.g. German bunds, UK gilts) then the USD move has legs.

Client flows to trade the USD have ramped up, with the break of 1.1000 in EURUSD getting clear attention, as it has in GBPUSD on the test of the 50-day MA, and USDJPY smashing through 148. The skew in USD directional risk remains towards higher levels this coming week and I see weakness in USDJPY and rallies in EURUSD offering entries to initiate new positions.

US CPI is the marquee data point for the week ahead

In the absence of any tier 1 economic data in Europe, Australia, the UK, and China this week, the focus falls again on the US economic data flow, where the highlight will be September CPI and PPI prints. With the Fed putting far greater emphasis on the labour market and feeling its war on inflation is over (for now), a lower-than-consensus outcome in the US CPI print is unlikely to lift expectations for a 25bp cut in November too greatly, given the barrier to a 50bp cut has been sufficiently lifted.

Conversely, we’d need to see a significant upside surprise relative to the core CPI estimates of 3.2% y/y to have the market really throw doubt about a 25bp cut at the November FOMC meeting.

With some 20 Fed speakers through the week, we should get a guide on how the respective Fed officials see Friday’s NFP print affecting their thought process on policy. One would imagine most should guide to a 25bp cut in November, however, should any hint at a pause in the cutting cycle the USD should continue to follow US Treasury yields higher.

US Q3 earnings start to roll in

The S&P500 closed on its session high on Friday, with longs showing little concern about holding exposures over the weekend and the prospect of gapping risk stemming from Israel/Iranian headlines. New ATHs in the S&P500 are just 15 points away, and as equity traders look towards the start of the Q3 reporting season, with JP Morgan leading us off on Friday, longs will be feeling confident that the bullish momentum in the S&P500, Dow, Russell 2k, and NAS100 holds.

To stay updated on all economic events of today, please check out our Economic calendar

Risk Warnings and Disclaimers

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Goldman Sachs

Economic

Stocks

The downdraft in stock markets in August, when US equities dropped 8% from the highs the previous month, may have been a warning shot, according to Christian Mueller-Glissmann of Goldman Sachs Research. While markets have mostly recovered since, the speed and drivers of the equity decline signal that there’s a higher risk of further setbacks.

“It shows that you're entering a more fragile macroeconomic backdrop,” says Mueller-Glissmann, who heads asset allocation research within portfolio strategy. “For the first time in a long time, you have more concern about growth. And when you have concern about growth, that can drive larger equity drawdowns, because equities are very sensitive to growth.”

The US labor market has softened, and global manufacturing data is showing signs of more weakening. China’s economy is sputtering, and consumer spending in Europe has been lower than some economists expected. “That has broadly increased equity fragility,” Mueller-Glissmann says.

But that doesn’t mean it’s time for investors to be bearish and avoid stocks. While equity declines are becoming more likely, those declines, or dips, could be an opportunity. “Ultimately, we would want to buy the dips as they occur, he says. “The August dip was obviously an opportunity to buy in hindsight, with equities just making new all-time highs.”

The risk of a bear market is still relatively low

Mueller-Glissmann’s team uses a framework using macroeconomic and market variables to assess the likelihood of a major bear market in equities, or drop from peak to trough, of more than 20% over 12 months, as well as the risk of a shorter-term hiccup, or correction, of about 10%.

Investors May Have Opportunities to Buy the Dips in the Stock Market_1

“This is really helping you to answer the question of whether you want to buy a dip,” Mueller-Glissmann says of the model.

Right now, the team’s research indicates the risk of a stock market drawdown has increased “a bit,” he says, as a result of negative growth momentum and slightly elevated stock valuations. That’s counterbalanced by a positive equity price momentum in the last 12 months, which reflects solid macroeconomic conditions. “These macro conditions usually linger — they don't disappear overnight,” Mueller-Glissmann says. “A strong positive trend in equities tells you the risk of an imminent bear market is low, because it usually takes time for macro conditions to deteriorate from such a healthy starting point.”

Even more importantly, inflation momentum has been declining for more than a year.

The US Federal Reserve reduced its policy rate in late September by 50 points to 4.75%-5%, showing the central bank is increasingly focused on economic growth, as opposed to stamping out inflation. Policymakers have scope to reduce interest rates to support the economy.

“You can have a correction, but most likely the central bank will step in and buffer the equity market and the economy,” Mueller-Glissmann says. “The Fed put reduces the risk of an equity bear market, though it cannot reduce the risk of an equity correction.”

Mueller-Glissmann’s team is “mildly pro-risk” in portfolio construction for the coming 12 months. Financial markets are “early in the late cycle” of economic growth: unemployment rates are low, profit margins are relatively high, and risk premiums for financial assets are low, for example. “All of those are typical late cycle tendencies,” he says.

Stocks should get some support because consumer and corporate balance sheets are in good shape. The savings rate for European consumers is very high, around 15%, and companies haven’t increased their debt burdens significantly. And while inflation seldom surges early in the economic cycle, that’s exactly what happened following the Covid pandemic amid supply-chain bottlenecks and pent-up demand. That resulted in a jump in interest rates, which prevented a build-up of leverage among consumers and businesses.

“There's re-leveraging potential left in the private sector that can drive growth,” Mueller-Glissmann says. “When you're early in a late cycle backdrop, which can last a long time, you want to be modestly pro-risk in your asset allocation, because equities are an asset that can still deliver good returns in these periods.”

Corporate credit, by contrast, can be a more difficult proposition. The extra yield relative to Treasuries is already low, and credit investors are still exposed to recession concerns.

The outlook for the 60-40 portfolio

Many safe-haven assets have already rallied going into the recent dovish Fed meeting. That may make some of them less likely to cushion a portfolio. But even so, Mueller-Glissmann sees scope for US government bonds to provide some buffer to stocks. Economic conditions could be conducive for the traditional 60-40 portfolio, which is split between stocks and Treasury bonds.

“The equity-bond correlation from here should be more negative,” he says. “This is consistent with the market shifting from inflation as a concern towards growth as a concern, and that means there is more benefit of 60-40-type portfolios.”

Investors May Have Opportunities to Buy the Dips in the Stock Market_2

But with potentially a smaller buffer from long duration bonds there is more value in alternative safe havens such as gold investments. Stocks with defensive characteristics could also be more valuable at this point in the economic cycle, as may some strategies using option overlays.

Overall, Mueller-Glissmann says it isn’t the time to completely avoid risk in portfolios. “Correction risk is probably a bit elevated, but bear market risk seems quite low,” he adds.

To stay updated on all economic events of today, please check out our Economic calendar

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Warren Takunda

Stocks

Asian shares advanced Monday after a surprisingly strong U.S. jobs report raised optimism about the economy, sparking a rally on Wall Street.

U.S. futures slipped and oil prices also fell.

Japan’s Nikkei 225 index gained 1.8% to 39,332.74 after the yen sank against the U.S. dollar. The Japanese currency has bounced on speculation over the central bank’s plans for interest rates since Prime Minister Shigeru Ishiba took office last week. Lower interest rates tend to boost prices of shares and other asset, and both Ishiba and the central bank governor suggested no hikes were likely soon.

Nintendo gained 5% following reports that a Saudi wealth fund was planning to increase its investment in the Kyoto, Japan-based video game maker.

In a policy speech on Friday, Ishiba said he wants to see salary increases that outpace inflation and that he will promote investment to create “a virtuous cycle of growth and distribution.” He promised economic support for low-income households and measures for regional revitalization and disaster resilience.

But he offered no major new initiatives, and his initial public support ratings are around 50% or lower, relatively low for a new leader, according to Japanese media. He plans to dissolve parliament on Wednesday for an election on Oct. 27.

After gaining briefly against the dollar, the yen fell back late last week. Early Monday, the dollar was trading at 148.45 yen, down from 148.72 late Friday.

Elsewhere in Asia, Hong Kong’s Hang Seng index rose 1.1% to 22,977.97, and the Kospi in Seoul surged 1.3% to 2,602.23.

Taiwan’s Taiex gained 1.8%.

Mainland Chinese markets reopen from a weeklong holiday on Tuesday, and the government said it plans to explain details of plans for economic stimulus at a morning news conference in Beijing. Before the Oct. 1 National Day holiday began, announcements of policies aimed at reviving the ailing property market pushed share benchmarks sharply higher and this week could bring more volatility.

“More fiscal stimulus to stabilize the property market and restructure local government debts, and structural reforms to address the over-capacity and deflation issues are needed to turn around the economy,” B of A Securities said in a research note, pointing to continued declines in home sales, housing prices and credit growth.

On Friday, the S&P 500 climbed 0.9% and got close to its all-time high set on Monday, closing at 5,751.07. The Dow gained 0.8% to 42,352.75, and the Nasdaq climbed 1.2% to 18,137.85.

Leading the way were banks, airlines, cruise-ship operators and other companies whose profits can benefit the most from a stronger economy where people are working and better able to pay for things. Norwegian Cruise Line steamed 4.9% higher, JPMorgan Chase rose 3.5% and the small companies in the Russell 2000 index gained 1.5%.

Worries over tensions in the Middle East still are casting a shadow, having pushed oil prices sharply higher as the world waits to see how Israel will respond to an Oct. 1 missile attack by Iran.

But U.S. benchmark crude oil slipped 19 cents to $74.19 per barrel early Monday, while Brent crude, the international standard, lost 29 cents to $77.76 per barrel.

Treasury yields soared Friday after the U.S. government said employers added 254,000 more jobs to their payrolls last month than they cut. That was an acceleration from August’s hiring pace of 159,000 and blew past economists’ forecasts.

Recent encouraging data on the economy have raised hopes that the job market will hold up after the Fed pressed the brakes on the economy through higher rates in order to stamp out high inflation.

The Fed has begun cutting interest rates and Friday’s jobs report was so strong traders are now forecasting it will not deliver another half-point interest rate cut before the end of the year after doing so in September.

In other dealings early Monday, the euro was unchanged at $1.0967.

Source: AP

Risk Warnings and Disclaimers

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Pepperstone

Economic

Stocks

According to FactSet data, earnings growth is expected at 4.2% YoY in the third quarter for the S&P 500 at large, a figure which would represent the fifth straight quarter of earnings growth for the index. Meanwhile, on a revenue basis, the S&P 500 is seen reporting growth of 4.7% YoY, the 16th consecutive quarter of revenue growth, if consensus expectations are realised.

Unsurprisingly, the market at large continues to look relatively expensive per traditional valuation metrics, with the forward 12-month P/E ratio standing at 21.4, broadly unchanged from this time a quarter ago, but considerably above the 5- and 10-year averages of 19.5 and 18.0 respectively.

A Look Ahead To Q3 24 US Earnings Season_1

As is typically the case, earnings expectations have been steadily but surely massaged lower throughout the last quarter. Consensus EPS expectations fell by 3.9% in the third quarter, a considerably larger decline than the 3.3% 5-year average, therefore giving companies substantial room to beat expectations when earnings are released.

This, in many ways, reinforces the importance of forward-looking guidance, particularly when considering the immediate market reaction to earnings releases. Participants will concern themselves not only with whether the company in questions has managed to beat what is a relatively low bar in terms of the report, but also whether or not the accompanying guidance points to a continuation of recent momentum over the quarter ahead.

On a sector basis, only three of the S&P’s 11 sectors are set to report a decline in YoY earnings, with energy set to report the chunkiest such fall. Of the 8 sectors seen reporting YoY earnings growth, Health Care, Information Technology and Communication Services are expected to report double-digit growth, with the latter two coincidentally being the best performing sectors in the index on a YTD basis.

A Look Ahead To Q3 24 US Earnings Season_2

As always, earnings season will get underway with the banks reporting before the opening bell on Friday 11th October. JPMorgan (JPM) and Wells Fargo (WFC) begin proceedings, followed by a bank earnings bonanza on Tuesday 15th, where Bank of America (BAC), Goldman (GS), and Citi (C) all report, with Morgan Stanley (MS) then rounding things out on Wednesday 16th.

Naturally, with the FOMC having now embarked on the process of policy normalisation, by delivering a ‘jumbo’ 50bp cut at the September meeting, investors will pay close attention for signs of how further rate cuts are likely to impact bank profitability.

Elsewhere, while their outperformance over the benchmark S&P 500 has not been anywhere near as vast this year, the high index weights possessed by the ‘Magnificent Seven’ stocks mean that their earnings releases remain key risk events for investors to navigate. Though their report is not due until 21st November, earnings from Nvidia will be closely watched, with the firm trading a whopping 150% higher YTD, and standing as the 2nd best performer in the S&P. More broadly, risks around the AI theme in general appear to have become somewhat more two-sided of late, as investors focus on return timescales for the significant capital expenditure which companies are currently making into this evolving theme.

A Look Ahead To Q3 24 US Earnings Season_3

Of course, earnings season is one of a handful of key risks that participants must navigate between now and the end of the year – namely, the presidential election on 5th November, and two further FOMC decisions, where 25bp cuts are likely at each.

Nevertheless, Q3 reporting season stands as the next of those risks on the horizon, and is particularly important given that solid earnings growth has been one of the key supporting factors - along with strong economic growth, and the forceful ‘Fed put’ – of my long-running equity bull case. I expect earnings growth to meet, or surpass, expectations, hence leaving the path of least resistance pointing to the upside, and with any equity dips likely to still be viewed as buying opportunities.

To stay updated on all economic events of today, please check out our Economic calendar

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ING

Economic

Energy

Telecom operators use electricity but aim to lower its consumption

While we enjoy the benefits of being able to make an instant connection to others, we seldom realise that this is facilitated through networks that are almost always switched on. And these networks need to be powered with electricity. According to the GSMA (an industry trade body for mobile network operators), 2-3% of the global energy consumption comes from the telecoms industry. The telecom sector uses this energy mainly to run its telecom networks. As we show below, there is a willingness within the telecom industry to reduce its carbon footprint.

This is also important because telecom providers are a provider of services to most other industries. Since an increasing number of industries disclose their climate footprint, they look to lower their emissions. They can do so through procuring services from energy-efficient companies or companies that procure renewable energy, which does not emit greenhouse gases. Customers searching for suppliers with a relatively small climate footprint are an opportunity for telecom operators. Nevertheless, there is also a financial benefit from reduced spending on energy, albeit small. We have previously estimated that energy costs for the sector were a relatively small part of the overall cost base, which includes depreciations. Around 2% of the total cost was energy-related, according to our earlier estimates. Finally, we also expect that green credentials could also benefit the brand, as consumers are likely sensitive to sustainability efforts. According to PwC’s 2021 Consumer Intelligence Survey, 76% of respondents expect they will search for alternatives when companies neglect the environment, employees, or the community in which they operate.

Many telecom operators have renewable electricity targets

As a start, many telecom operators that saw the need to lower their ecological footprint, began reporting on their energy consumption. Already in 2019, the GMSA announced that many mobile telecom operators would start disclosing their climate impacts. They have also started consuming renewable energy years ago for some of their operations, to reduce the emissions coming from their energy consumption. According to the European Telecommunications Network Operators' Association (ETNO), many European telecom operators target to reach their net-zero goal by 2030 for their Scope 1 and 2 emissions and 2040 for their Scope 3 emissions, as can be seen in the table below. Also, many green bonds have been issued throughout the last years. The proceeds of these notes are ear-marked for investment projects that increase their energy efficiency. Examples of companies issuing green bonds are Vodafone, KPN, Proximus, Telefonica and Orange.

Many telecom companies aim to have net-zero emissions

Note: These are company target dates. The Science Based Targets initiative (SBTi) website provides current information whether the SBTi has validated the net-zero target.

Source: ETNO (2024)

Telecom networks drive energy consumption of telecom operators

The energy consumption of communication networks is the main driver of the overall energy consumption of telecom network operators. KPN reports that 95% of its electricity consumption is used for its mobile and fixed networks. There are a few other domains where they can save energy, such as the cost of heating and transportation, but this will have a relatively small effect, given the limited contribution to the overall number. In the following sections we’ll dive into the energy consumption of fixed and mobile networks and will touch upon the energy efficiency of data centres and other energy uses.

Fixed networks can become more energy efficient

The employment of fibre technologies has enabled a major improvement in the energy efficiency of fixed networks. Legacy technologies, such as full copper networks, are much less energy efficient. However, fibre investments only help to reduce the overall electricity consumption when legacy (copper) networks will be switched-off. Interestingly, fibre networks also offer other important benefits, such as much higher speeds and a high reliability. Fibre connections can reach speeds of 1Gb/s to 10Gb/s, whereas speeds of xDSL solutions (a family of copper/fibre solutions) are limited to tens or sometimes a few hundred Mb/s. This derives from the fact that a data signal can travel over longer distances through a fibre cable than through copper without amplification, while a signal over a fibre cable is not prone to magnetic interference. These characteristics imply lower maintenance costs and few repairs, which also helps to lower the environmental footprint because maintenance workers do not have to travel.

As research by consultant Analysis Mason shows, a fibre line based on GPON technology requires about half the energy as a Docsis3.1 based network, while a GPON line requires c.42% less energy than a VDSL-based network. An upgrade to networks based on fibre technologies therefore also lower the CO2 emissions. Telefonica was one of the first companies to recognise the benefits of lower power consumption of fibre solutions and rolled out a vast fibre network throughout Spain. Contrary to our expectations, we did not find an overall reduction in electricity use for Telefonica Spain, as we will show below. Causes are related to a delayed copper switch-off and Telefonica’s own objectives. However, another company investing heavily in its fibre grid KPN does report a lower overall electricity consumption.

Fibre provides an energy efficient fixed broadband connection (Watts per line)

Power consumption of network and customer premises equipment per line at full usage

Source: Analysys Mason

Mobile networks can become more energy efficient

When evaluating the energy uses of mobile telecom companies, the Radio Access Network (RAN) stands out. The RAN is the key enabler of mobile communication as it connects users to the core network. Three main components can be distinguished: antennas, radio equipment and baseband units. The baseband units are essential pieces of equipment to process and manage data traffic exchanged between the customer and the core network. Most of the energy utilised by a mobile site is being used by the RAN, about 60% according to McKinsey. Many innovations have taken place throughout time to enhance the efficiency of the RAN equipment. For example, an innovation by Ericsson reduced the energy consumption of a 5G radio by 40%. The triple-band, tri-sector radio replaces nine legacy radios. Energy use can also be reduced through shared use of RAN equipment. Orange argues that a RAN sharing agreement can reduce energy consumption by 20%-30%. In Poland, Orange shares its RAN with T-Mobile. This has led to increase in the energy consumption per site by 14.5%, but the number of sites has been reduced by 20%. Also, the number of sites should have been doubled to reach a similar quality of service as without the RAN sharing.

Other ways to reduce energy consumption of mobile equipment are antennas exhibiting a traffic-dependent energy use, more efficient cooling, and an improved support for optimised energy consumption in line with varying data traffic. However, as 5G uses more frequency bands and needs more sites, this may offset the benefits from energy conservation measures. There are therefore two views on the electricity needs of future mobile networks, as also articulated by the GSMA. Electricity consumption could go down because of more efficient equipment. However, the opposing view is that consumption goes up, because of better mobile coverage (a higher network density) at multiple frequency bands. We will show below that we also find opposing patterns in the data, with BT showing an increase in electricity consumption, while KPN brings its electricity needs down. Nevertheless, it is clear that more efficient equipment is key to lower electricity consumption.

Other services also require energy

The other uses of energy by telecom operators are mainly data centres, transportation services and buildings. Data centres are an important feature of telecom networks, but not the component requiring most energy. Note that the large data centres are mostly operated by technology companies, telecom companies have often sold them. For now, we suffice by stating that telecom operators should employ data centres with a high energy efficiency, as the procured services are included in the Scope 3 emissions of telecom operators. We have provided a more elaborate discussion around data centres in a previous article. Other ways a telecom operator can save energy are through the use of energy-efficient buildings and an efficient use of transportation.

Reducing electricity consumption is clearly possible as KPN and Telecom Italia show

Some companies, like KPN and Telecom Italia managed to get their energy consumption down, despite increasing traffic. The energy consumption of KPN is 42% lower than in 2010. Note that KPN only procures green electricity coming from local and European wind farms. 95% of KPN’s electricity consumption is consumed in the mobile and fixed networks. The 7% lower electricity consumption in 2023 mainly came from improved energy efficiency of networks. In 2022, consumption was 5% lower, while in 2021 KPN reported a 12% decline in electricity consumption related to the phasing out of a legacy (TDM/PSTN) telephone network and the migration from a site in Amsterdam to other sites. However, now that KPN will activate additional 5G spectrum, we expect that it will become more difficult for KPN to save energy going forward, especially with a strong increase in mobile data traffic and potentially new 5G services. Although we do expect KPN to meet its 2030 energy reduction target target, it will be interesting to see how it manages the future capacity growth of its mobile networks.

In Italy, Telecom Italia uses 28% less energy than in 2016, while 65% of its Italian electricity consumption was based on renewable energy. Telecom Italia works to increase the efficiency of its infrastructure through eco-efficient technologies and site decommissioning. It has reduced its energy consumption by 28 GWh through the decommissioning of 56 fixed network exchanges. It has also decommissioned c.19,000 mobile network sites leading to savings of c.117 GWh. Also, over 13,000 public telephone cabins are no longer in use. The decommissioning of sites, therefore, has saved 145 GWh of energy consumption. A further 50 GWh was saved due to energy efficiency measures. This shows the way forward for other companies, as not all companies are there yet.

KPN and Telecom Italia did manage to lower their electricity consumption

(Gwh)

Source: Company data

Electricity consumption is not down everywhere, just look at Telefonica and BT

Contrary to the excellent initiatives at some of the leading companies, energy consumption has not been reduced at some other companies. Despite rolling out energy efficient fibre, Telefonica did not manage to get its domestic electricity use down – it has remained at the 2016 level. The more positive news is that 50% of Telefonica’s power use for its technical buildings is from renewable power. More strikingly, BT reported a 16% increase in electricity consumption in the UK since 2015. The good news is that almost 100% of its domestic electricity consumption is from renewable energy sources. To us, it is not immediately clear why BT is using more electricity and why Telefonica did not manage to get its power consumption down. BT reports that its main focus is to lower emissions through purchasing renewable energy and it is making good progress in that regards.

With respect to electricity consumption, BT does mention that it is constructing more energy-efficient fixed and 4G/5G networks, while switching off legacy ones, but is does not seem to provide more detail on its efficiency progress. Telefonica aims for a stable electricity consumption in Spain while growing its data traffic. As the full copper switch-off is happening in 2024, the improved energy efficiency due to the copper switch-off is not yet in the data. Also, it is likely that an improved coverage for 5G is increasing Telefonica’s electricity consumption. Decommissioning legacy sites and legacy infrastructure is sometimes difficult because of competition regulations. It is also possible that the companies are rolling out additional mobile sites to increase 5G coverage or are not using the most efficient equipment. However, as industry leaders are steering the way forward, this indicates to us that the lagging companies can also step-up their game and become less energy intensive.

Telefonica and BT did not manage to lower their electricity consumption

(Gwh)

Source: Company data

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Headline nonfarm payrolls rose by +254k in September, the fastest pace since March, and considerably above consensus expectations for a +150k increase, while also printing to the upside of the always-wide forecast range of +70k to +220k. At the same time, the August and July nonfarm payrolls figures were revised solidly higher, by a net +72k, in turn seeing the 3-month average of job gains rise to +186k. While still below the breakeven rate, said average is now at its highest point since May.

Digging a little further into the data, the sector split of employment growth shows job gains broad-based across most sectors of the economy. The Manufacturing sector was the only one to lose jobs, with employment contracting for a second straight month. Those sectors seeing the biggest job gains remain Leisure & Hospitality, and Education, which have underpinned the majority of job gains in recent months.

Sticking with the establishment survey, the labour market report showed that earnings pressures remained relatively cool. On an MoM basis, average hourly earnings rose by 0.4% MoM, unchanged from the pace seen in August. In turn, this saw the annual rate quicken to 4.0% YoY, the fastest rate since May.

Such a pace of earnings growth, however, is one that remains broadly compatible with a sustainable return towards the 2% inflation target over the medium-term. It is also unlikely to worry FOMC policymakers, who have already obtained sufficient confidence in such a return to target, as demonstrated by last month’s ‘jumbo’ 50bp rate cut.

Turning to the household survey, unemployment unexpectedly fell to 4.1%, its lowest level since June, and a further pullback from the 4.3% cycle highs seen back in July.

Meanwhile, other measures of labour market slack pointed to conditions remaining relatively tight, with underemployment falling 0.2pp to 7.7%, as participation held steady just shy of cycle highs, at 62.7%.

Unsurprisingly, given the much stronger than expected data, market-based rate expectations underwent a significant hawkish repricing. Having, pre-payrolls, discounted around a one-in-four chance of a 50bp cut at the November FOMC meeting, the USD OIS curve now implies just a 5% chance of such an outcome. Further out, around 10bp of easing has been priced out, in total, by year-end, with the OIS curve pricing just 51bp of cuts by December.

Unsurprisingly, this hawkish repricing sparked a fairly significant cross-asset reaction.

This was most obvious in the Treasury complex, where the front-end of the curve sold off aggressively, with 2-year yields rising as much as 15bp, north of 3.85%. The curve as a whole bear flattened, with 10s and 30s rising by 9bp and 5bp apiece, taking the 2s10s spread back into single digits.

Meanwhile, the dollar benefitted from the rates sell-off, with the DXY extending recent gains into a fifth straight day, rising north of 102.50. Key levels gave way across the G10 space, with the EUR dipping south of 1.10 to a 7-week low, while cable briefly surrendered the 1.31 handle, the Aussie slipped under the 68 figure, and USD/JPY rose north of 148.

Equities also advanced, with payrolls sparking a ‘good news is good news’ reaction, as participants focused on the macroeconomic picture painted by the report, as opposed to any potential hawkish policy implications. The front S&P future gained around 0.7%, while the Nasdaq traded over 1% higher.

Overall, though, despite the much stronger than expected figures, this report is unlikely to materially alter the FOMC's policy outlook.

While focus remains squarely on the employment side of the dual mandate, Chair Powell's recent assertion that the Committee is "not in a hurry" to cut quickly, along with today's incredibly solid data slate, means that a return to a more normal cadence of 25bp cuts is likely at the November meeting, and at each meeting beyond that, until the fed funds rate returns to a neutral level next summer. That said, the data-dependent FOMC will respond if labour market conditions weaken, with larger 50bp cuts on the table particularly if unemployment rises north of the 4.4% median forecast for this year and next.

For sentiment, the forceful 'Fed put' should see the path of least resistance continuing to lead higher for equities over the medium-run, though conviction in the short-term could well be somewhat lacking, owing to ongoing geopolitical risks in the Middle East.

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