The earlier timing of the election is a surprise relative to market expectations. If the polls are right, though, the outcome – a Labour win – appears to be widely expected by investors. The next UK government will have little fiscal space for major initiatives. That said, there could be a range of modest effects impacting different groups of consumers and businesses to varying degrees. We still believe that the Bank of England is likely to lower interest rates this summer, as the inflation trajectory is now more under control. Gilt yields should fall further, though gently. The pound sterling could regain some value versus the US dollar, but only when the US Federal Reserve starts cutting rates too, probably towards year-end. Our UK equity exposure is in line with our long-term asset allocation, with an extra, modest exposure to smaller capitalisation stocks as part of our global small-cap position.
Going to the polls slightly earlier than expected, still with limited room for fiscal manoeuvre: As announced last week, UK Prime Minister Rishi Sunak has called a general election for 4 July, earlier than expected (most commentators pointed to October or November as more likely). As his Conservatives are lagging behind the Labour opposition by about 20 percentage points in the polls, should these voter intentions materialise, Labour would win. Labour leader Keir Starmer could take power somewhat earlier than expected, but that doesn’t change the outlook for the UK at this stage. We still think the economy is recovering gradually and should continue to do so, with interest rate reductions this summer. We believe that the next UK government will have little fiscal room for manoeuvre. Labour’s policies should be relatively neutral for the UK’s long-term economic growth, in our view. However, details are lacking, and there’s obviously a lot of variability in the type, extent and effects of any forthcoming change.
Broader economic policies could have a range of effects: As usual, not all potential changes point in the same direction: a possible strengthening of unions’ bargaining power could hypothetically impact business activity and confidence or even reduce the degree of economic flexibility in some sectors. However, it could also result in a modest boost to spending power for certain household categories that have a high spending propensity, maybe raising overall consumer spending for some time. What’s more, plans to make more land available for housing around key urban centres could modestly mitigate the housing shortage, which is a key drag on the mobility of labour in the UK (a potential cause of labour shortages) and real income growth, given elevated rents and housing costs. Having said that, the devil is in the details, and the precise impact of these policies can only be sketched with a low degree of accuracy.
The near-term Brexit impact is relatively stabilised: Sunak has already settled the terms of Brexit with the EU through his deal over Northern Irish border controls. Removing the risk of sustained trade tensions with the EU has contributed to a rebound in UK business sentiment and investment from its post-referendum weakness. Starmer may find it easier than the pro-Brexit Conservatives to strike some further, limited deals with the EU. This may help contain the cost of Brexit by mitigating the administrative cost for some EU-UK transactions and keeping UK regulations a bit more aligned with those in the EU than otherwise would be the case. However, whether this will happen remains to be seen. At this stage, some of the border checks and procedures are still being implemented, possibly making international trade slower going forward.
Interest rates and bond yields set to trend lower this summer: The July election may further raise the probability that the Bank of England will deliver its first 0.25 percentage point rate cut on 1 August rather than on 20 June. We expect the first rate cut this summer because inflation is down to 2.3% (close to the Bank of England’s 2% target). However, we believe the central bank will want to ensure that this isn’t just a temporary inflation decline, given that economic growth is looking better, services prices remain sticky and wage growth still relatively robust. Should it want extra confirmation that inflation is likely to meet its target, as we believe, August looks more likely. Gilt yields are likely to gently trend lower, too. And, if the plan to stick to budgetary discipline remains, which looks likely, we expect gilt issuance to have a limited impact on the bond market.
Sterling to gradually appreciate versus the US dollar once the Fed lowers rates: The pace of rate reduction remains quite uncertain. This is because inflation looks sticky in the US. In turn, this means that the Bank of England may refrain from cutting too much if the US Federal Reserve doesn’t for a while longer. If the UK saw lower rates versus the US, the pound sterling would risk depreciating versus the US dollar, as exchange rates tend to be driven by interest rate differentials in the near term. If that happened, then import price inflation would accelerate in the UK, thus putting the achievement of the central bank’s inflation objectives at risk. Putting it all together, we believe that the US dollar is likely to stay on the strong side versus sterling for the time being. But, if the Fed begins reducing rates towards year-end as we think, then the US dollar could weaken somewhat and sterling recover.
Keeping our UK equity exposure in line with long-term allocation: Relative to our strategic asset allocation, our UK equity exposure is ‘neutral’, nothing less but also nothing more. While our approach is global in nature, and our largest absolute exposure is US equities, that ‘neutral point’ is somewhat higher than the weight of UK equities in global equities. Generally speaking, large capitalisation stocks in the UK tend to be driven more by global factors than domestic ones. This is because these are typically companies operating across the world. From this perspective, currency weakness beyond our base case could be supportive. The composition of the main equity indices matters as well: the four largest sectors are pharmaceuticals, oil & gas, metals & mining and banking services, which together account for approximately 47% of total market capitalisation of the FTSE 100 equity index. So upside surprises to, say, oil prices or certain commodities could be supportive for the respective sectors, too. Tactically, we also have a global small-cap equity exposure. Of these smaller capitalisation stocks, a minority is UK stocks.
The UK election might result in tax changes potentially having a variety of effects depending on individual circumstances, some of which not fully known at this stage. Should you like to discuss any of these aspects, our Client Advisors and Wealth Planners will be happy to help.
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Information correct as of 28 May 2024.
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