That Labour won a strong absolute majority, and the Conservative Party sank to the lowest result ever isn’t a surprise for markets, given the polls. The next government plans to follow the same fiscal rules as the outgoing one and so, in our view, it will have limited fiscal space. However, there could be modest effects on different groups of consumers and firms. If economic growth were to fall short of the base case and the spending plans remained unchanged, small tax hikes could become a possibility. With inflation now in line with the central bank’s target, we believe that the Bank of England is likely to lower interest rates this August. Gilt yields should fall further, though gradually. The pound sterling could regain some value versus the US dollar towards year-end, which is when we think the US Federal Reserve will likely start cutting rates. Our UK equity exposure is in line with our long-term asset allocation, nothing more but also nothing less.
Starting a new phase with limited room for fiscal manoeuvre
Labour leader Keir Starmer is taking power somewhat earlier than expected at the start of the year, but that doesn’t change the outlook for the UK at this juncture. We still think the economy is recovering gradually and should continue to do so, with interest rate cuts this summer. And we still believe that the next UK government will have limited fiscal room for manoeuvre on the assumption that it would want to follow the same fiscal rules as the outgoing one. Labour’s policies should be more or less neutral for the UK’s long-term economic growth, in our view. However, precise details are still lacking and, of course, there’s a wide range of scenarios when it comes to the possible effects. In general, in the near term, we’d expect somewhat firmer support for consumer spending.
Taken at face value, this would imply modest upside pressure on wage growth and, therefore, inflation. Labour’s pledge to introduce a “genuine living wage” potentially points to further hikes in the National Living Wage, but the magnitude remains quite uncertain. Labour’s fiscal policies would also likely have an impact on inflation via the proposed introduction of VAT on private school fees. While there’s no official confirmation, the government would likely require further modest tax increases if it wanted to leave fiscal headroom at current levels, with media reports suggesting that capital gains and inheritance taxes could go up.
Broader economic policies could have a range of effects
A possible strengthening of unions’ bargaining power could impact business activity and confidence, and reduce economic flexibility in some sectors. However, it could also modestly boost buying power for certain household categories that have a high spending propensity. What’s more, reforms to the planning system could boost housebuilding and productivity; higher public-sector investment is likely to support productivity too, and overall economic growth. Closer trade ties with the European Union (EU) could mitigate some of the Brexit costs by lowering the administrative cost for some EU-UK transactions and keeping UK regulations more aligned with those of the EU.
Conversely, higher taxes (should they materialise) could reduce incentives to invest. Furthermore, Labour’s pledge to cut net migration could negatively affect the supply of labour in some sectors that are already being impacted by shortages. These effects seem more likely over the medium term and are difficult to quantify without further details. These hypothetical near- and medium-term changes could result in slightly stronger economic growth and slightly higher inflation compared to current policies. The implications for the Bank of England would likely be somewhat limited, but with risks of slower interest rate cuts if Labour delivered a sizeable increase in the National Living Wage.
Interest rates and bond yields are set to decline, and sterling to recover gradually
With inflation basically in line with the 2% target, we think the Bank of England will deliver its first 0.25 percentage point rate cut on 1 August. Our forecast assumes gradual rate reductions, with the second cut this autumn. We think the central bank will want to ensure that this isn’t just a temporary inflation decline. This is especially important as economic growth is looking somewhat better, services prices remain relatively sticky, and wage growth is still reasonably robust (which could make inflation more enduring than assumed). Given this monetary policy and inflation outlook, gilt yields are likely to trend lower, too, albeit gently. If the plan to stick to budgetary discipline remains, which we think looks likely, we expect debt issuance to have a relatively limited impact on the gilt market.
Beyond the first couple of cuts, the pace of further rate reductions is still uncertain. The Bank of England may refrain from cutting too much if the US Federal Reserve (Fed) doesn’t cut for a while longer. This has to do with the key driver of foreign exchange flows in the near term: interest rate differentials between countries. If the UK saw lower rates versus the US, the pound sterling would risk depreciating versus the US dollar. In turn, this boosts UK import price inflation and, therefore, puts the achievement of the central bank’s inflation objectives at risk. This means that only when the Fed begins reducing rates, which we think is plausible towards year-end, can the US dollar weaken somewhat and sterling recover.
Maintaining UK equities in line with long-term allocation
One feature of our strategy is that we invest globally. Our largest absolute exposure is US equities. This market captures long-term growth via its quality, depth, dynamism, and exposure to themes such as artificial intelligence and technological innovation. Relative to our long-term strategic asset allocation, our UK equity exposure is ‘neutral’. That said, the neutral point for UK equities is somewhat higher than their weight in global equities. Generally speaking, we’re mostly exposed to large capitalisation stocks in the UK, which tend to be companies operating across the world and, therefore, driven more by global factors than domestic ones.
This approach means that currency swings do matter. Any sterling weakness beyond our expectations could support large-cap equities in the UK. And, of course, the composition of the leading equity indices matters, too. The four largest sectors in the UK are pharmaceuticals, oil & gas, metals & mining, and banking services, which together account for over 45% of the total market capitalisation of the FTSE 100 equity index. So, upside surprises to, say, oil prices or certain commodities, interest rates, or regulations, could be supportive for the respective sectors.
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Information correct as of 5 July 2024.
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