What a July election means for bond markets

James Yardley 03/06/2024 in Fixed income

The trajectory of the stock market may get more attention, but in reality, fixed income markets tend to be more sensitive to changes in politics. Gilt and currency markets can be a barometer for sentiment towards the different parties. With that in mind, how might they respond to the upcoming UK election?

Since the election was called for 4 July, the UK government bond markets have been stable. This suggests they do not fear a change of government. If anything, the slight appreciation in the pound suggests financial markets might welcome the increased stability brought by a majority Labour government.

That said, there are subtle ways in which an election might shift gilt markets at the margin. John Chatfeild-Roberts, head of the Jupiter Merlin multi-manager team, believes it could affect the timing of a rate cut.

He says: “Overtaken by events, it is a moot point whether a June cut (the MPC meets on the 20th) is now a possibility at all given it would be two thirds of the way through an election campaign; however independent, the Bank would be open to the charge of helping the Tory narrative of wanting to see lower mortgage rates; any decision by the Bank to move 14 days before polling but after nine months of doing nothing is politically charged.”

Any deferral of rate cuts puts continued pressure on UK households. While we have already passed the peak of remortgaging, forecasts suggest just over 283,000 UK mortgages will need refixing in the third quarter of 2024*.

However, Felipe Villarroel, partner at TwentyFour Asset Management, which run the Elite Rated Corporate and Dynamic Bond funds, argues that a rate probably wouldn’t have happened anyway. He says: “The Bank of England just does not have good enough data to embark in the rate cutting process. Traders seem to agree, judging by the moves in the gilt market and in the implied probability of a June cut.

“With the UK economy recovering at the margin and slightly better growth expected going forward, the chances of a hard landing in the short term have actually decreased, which increases our confidence in that betting on large capital gains from government bonds is not the right strategy.”

What about borrowing?

The big fear for an incoming labour government is that they will drive up borrowing at a time when the UK can ill-afford it. The consequences of this type of recklessness were shown in spectacular fashion when Liz Truss’s economic plans sent the UK 10 year bond yields from 3.1% to 4.4%** in just a few weeks.

However, the UK’s vast structural debt leaves little flexibility and both parties appear to recognise their fiscal limitations. John Chatfeild-Roberts says: “At this stage given the constraints and the sensitivity of the bond markets it is not entirely surprising that what is on offer from the Tories and Labour in terms of economic policy is so little different: if it were a decorator’s fancy paint colour chart, it would be like distinguishing between “Elephant Breath” and “Grey Mouse”.”

James Lynch, investment manager on the fixed income team at Aegon Asset Management, which runs the Elite Rated Aegon High Yield Bond fund, says there are risks on the Tory side as well, but these are less likely given the timing of the election: “An early election means there will be no final ‘give away’ budget from the government to win over last minute voters.”

He believes any potential new government ‘gets it’ in terms of there being no quick fixes to a return to growth: “They know they cannot spend their way to growth via borrowing in the gilt market (in contrast to the Liz Truss government). At the margin, there will likely be an increase in tax take as extra investment will be needed in some public services, and the plan for GB energy.”

The performance of sterling

Sterling has gained ground since Sunak called the election, although the pound has been generally stronger since mid-April. Currency markets prefer stability, which would normally mean continuity of government. However. In the UK, there may be a sense of greater stability from an incoming Labour government, given the turbulence of the last few years of Tory rule.

James Lynch says: “The new parliament with a large Labour majority will bring a sense of stability; most likely, five years of the same chancellor and prime minister should mean a coherent fiscal plan that is unlikely to be deviated from in short order.” This is likely to be one of the factors pushing sterling higher.

What else should investors consider?

In reality, the impact of the election on the gilt market is likely to be marginal, compared to other factors such as inflation. Here, there is some good news. Felipe Villarroel at TwentyFour says many parts of the inflationary bucket are showing downward pressure: “The electricity, gas and other fuels component remains one of the disinflationary process’ driving forces. After the painful adjustments in 2022 and early 2023, this category has been in deflation mode since mid-2023. In April, the deflationary trend became more acute with year-on-year inflation of -27.1% compared to -18.2% in March.

“Secondly, core goods (that is excluding energy and food) disinflation is still helping the headline number. Core goods account for 29% of the Consumer Price Index (CPI) basket and all subcomponents showed lower year-on-year inflation than in the previous month. These include clothing, household goods, medical products and recreational goods among others.”

The problem has been services inflation, which is not playing ball. Year on year services inflation has dropped just 0.1% (from 6% to 5.9%), and has shown signs of reaccelerating more recently. Felipe adds: “Wages play an important role in the cost structures of services companies and a lot more progress in this area is needed in order to see a strong decline in services inflation, in our opinion.”

Equally, the relative strength of the economy will play a role. Economic growth in the UK has recovered, but remains anaemic. John Chatfeild-Roberts points out that the currency level of 0.6%*** in the first quarter is no more than the average of the pre-pandemic quarterly rate: “Thanks to the erosion in productivity and the burgeoning zombie economy with all its inefficiencies, the average rate of real growth in the period following the Global Financial Crisis (GFC) and the advent of quantitative easing was lower than it was before the GFC. As it is, the ONS reckons that compared with the first quarter of 2023, the economy is 0.2% bigger year-on-year.”

For the time being, investors can take heart from the fact that gilt and currency markets remain stable in the face of a likely Labour government. This gives a sound underpinning to all UK assets and makes it marginally easier for the incoming government to manage its difficult financial inheritance.

*Source: Uswitch, UK remortgage statistics 2024, 28 March 2024

**Source: Investopedia, 20 October 2022

***Source: Jupiter Asset Management, 24 May 2024

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