What the UK’s political ‘earthquake’ means for growth, the pound, markets and finance

Written by Eleftherias Cortalis

Although Labour’s landslide victory was largely understated in opinion polls, the new government faces huge economic and financial challenges.

Political ‘earthquake’ hits UK

The UK has voted and the outcome is clear: Labour will govern with a solid majority for the next five years. Financial markets, such as the pound, have barely reacted at all. In stark contrast to the political events across the Channel in France, the outcome of the UK election has been a foregone conclusion for months. ING notes that this lack of market volatility is a welcome change after a series of episodes of political turmoil. It is also a marked departure from the last election in 2019, when markets had to contend with uncertainty over the UK’s future trading relationship with the EU, the risk of a second Scottish referendum, and some bold commitments on fiscal policy.

Of course, investors have not forgotten the 2022 mini-budget and unfunded tax liabilities crisis that sent waves of anxiety through the UK bond market, the Dutch house notes. Since then, risk premiums have fallen sharply while there has been an acknowledgement that UK politicians are moving cautiously with the focus on bond markets.

The financial challenge facing the Labour Party is great.

However, ING stresses that the challenges facing the UK’s public finances have not gone away. The rise in bond yields reflects the fact that public debt is approaching 100% of GDP and the deficit is 4.4%.

Global bond investors have become more sensitive to fiscal sustainability in recent months, and there is a sense that Labour will inevitably have to deliver on its campaign promises. The party has been clear that it wants to avoid further austerity. But its revenue pledge amounts to roughly 0.5% of GDP. Labour has ruled out raising taxes, which account for 80% of government revenue.

ING points out that growing the economy, a central commitment of the Labour Party, is unlikely to “work”, even if the outlook improves. Growth in the second quarter is likely to be 0.4-0.5% after 0.7% in the first quarter. Whether this will continue is highly questionable.

“It is not us who the government has to convince,” the council stresses. “It has to convince the independent Office for Fiscal Responsibility (OBR) that its plans mean higher productivity and a ‘brighter’ economy. The truth is that the OBR’s growth forecasts already look very optimistic. If anything, they may end up being downgraded, further reducing the new prime minister’s room for manoeuvre.”

The business has many options.

The challenge is huge, but it would be wrong to say that Labour is out of options, ING points out. In fact, the new government may find it easier to find extra money in its first budget than many think.

Small changes to the fiscal rules and several adjustments to secondary taxes and related exemptions could provide the money needed to complete the planned spending cuts. These cuts look set to exceed 3% a year in real terms, and many economists believe this is unrealistic given the current pressures on the services sector. Ending them would cost around £20bn a year.

Finding that amount is possible, but that only maintains the level of spending. The Dutch House points out that a more ambitious approach to government services, given the long-term challenges of an ageing population and a struggling health care system, will require more money.

Bigger tax increases may be inevitable, but they probably won’t happen this year. A Labour government will also be inclined to borrow more to fund investment, with its manifesto pledging just £3.5bn of that. That’s a drop in the ocean, but it’s a statement of intent nonetheless. Labour is clearly treading carefully, given how markets will react in 2022 to plans to borrow more to fund tax cuts. But investors will be “more receptive” this time around, ING said, assuming that the extra lending is intrinsically linked to investment in productive infrastructure and is done within a clear framework.

Election result gives green light to cut interest rates in August

All of this will keep the new prime minister busy in the coming weeks. In the meantime, the absence of seismic changes in public finances means the Bank of England can continue its mission of cutting interest rates. Markets are pricing in a 60% chance of a rate cut in August, which ING believes is very low.

BoE officials have not made any public comments during the election campaign, which explains why UK interest rates have largely tracked the movement in the US. However, pay attention to BoE comments next week, which could seek to bolster expectations of a rate cut in August. After all, some policymakers thought a rate cut could have been taken at the last meeting in June, and the BoE has downplayed recent upside inflation surprises. ING expects three rate cuts this year, starting in August, more than markets currently anticipate.

If Labour’s fiscal plans don’t rattle investors and the Bank of England can actually start cutting interest rates, UK 10-year bond yields could end the year well below 4.0%, ING estimates. Further pressure on the residual risk premium linked to financial uncertainty could contribute to lower yields. So too could concerns about the global growth outlook.

As far as the path of the pound is concerned ING notes that in the medium to long term, the fiscal constraints facing the new government point to weaker economic fundamentals for sterling and some pressure.

The GBP/USD exchange rate is estimated to move to 1.25 and the EUR/GBP rate to 0.86 if the Bank of England cuts interest rates in the summer. The risks to this forecast come mainly from the possibility of a weaker USD due to weak US data, for example, or a weaker EUR (given the political situation in the EU) and less of a bout of sterling strength.

Read more:

* Dissecting the British Election Result