New government, same economy
Posted 5 July 2024
Keir Starmer was not wrong when he called this an historic victory. It is the Labour party’s first election win since 2005, ending 14 years of Conservative rule and handing the latter party its worst ever defeat. The results were emphatic, but full of contradictions. Labour won one of the largest parliamentary majorities in history with the lowest ever winning vote share. Britain’s right-wing party collapsed, but the Reform party outflanking it, surged. The new government crushed the old by emphasising the need for change, but its policy agenda emphasises stability and continuity. And the contradiction most relevant to us as investment professionals: capital markets look unmoved by the political earthquake.
Labour will move quick but tread light.
UK stocks did rally on Friday morning, and have had a decent enough week overall. Some media outlets put this down to Starmer’s pro-business agenda. Housebuilders are up 3% on the day so far, and 8% on the week, following Labour’s promise to build 1.5 million homes in the next parliament. But on the whole, that link is debatable. The uptick for the FTSE 100 – an index dominated by multinationals – was part of a broader rally in global stocks. The result was almost exactly in line with expectations, too, so there was little new information. More importantly perhaps, there were no surprises to upset markets. When UK equities sold off last month, we said it was not about investors fearing Labour. This week’s rally has little to do with welcoming them either.
The new prime minister’s cautious approach helps explain markets’ nonchalance. Labour has committed to not only maintaining, but strengthening, the fiscal discipline promised by outgoing chancellor Jeremy Hunt, by giving the Office for Budget Responsibility more power. It is fitting that former prime minister Liz Truss lost her seat on Friday morning, as her 45-day premiership has influenced fiscal policy more than the big ideas of either main party. The Conservatives realised after the ‘mini budget’ fiasco that growth oriented expansion means nothing – or worse – if it is undermined by sharply higher bond yields and mortgage rates. In some ways, the market reaction to Truss’ experimental fiscal foray firmly established the bond markets as a non-political, usually invisible, but occasionally vicious opposition that will hold any government to account. Labour is well advised to continue practicing that wisdom.
That means any growth upside from Keir Starmer’s government will be moderate at best, but it should also mean bond and currency stability. It was notable this week that UK bond yields came down quicker than counterparts in Europe – where the spectre of a destabilising far-right French government still looms. Labour will want to hit the ground running and be seen implementing change fast, but immediate changes will likely be shallow. We wrote recently that Labour will probably seek to increase revenue from capital gains tax, but this is likely to have less of an impact on investment values than economic growth. The new government will take heart that those growth indicators are already improving, and will hope that stability allows this to continue.
Fiscal instability in the US?
Starmer’s caution is a far cry from the offerings being made by US politicians. The federal government’s borrowing metrics – in particular, debt-to-GDP – have been deteriorating for well over a decade, and the trend looks set to continue regardless of who wins the presidential election in November. Former president Donald Trump famously broke from the ‘balanced budget’ orthodoxy of previous Republicans when he was in office, by cutting taxes at a late stage of the economic cycle. Fiscal policy had to be dramatically loosened again during the pandemic, and president Biden maintained this laxity with his pro-growth investments.
Interestingly, many economists – like researchers at Morgan Stanley – expect US fiscal policy to be looser if Trump wins than Biden. Biden’s poor debate performance and calls for him to step down as Democratic candidate have therefore increased market fears about fiscal instability. Trump would likely seek to cut taxes again. That could well deliver a short-term growth boost, but could also threaten to push up bond yields and prevent the Federal Reserve from substantially easing monetary policy.
The US usually avoids punishment by international bond markets, thanks to its status as the world’s largest economy. But this will be tested the worse its fiscal situation becomes. Tellingly, Fed chair Jay Powell warned about the unsustainability of US debt-to-GDP this week – a highly political topic that monetary policymakers usually steer clear of. He seems to be fearful, perhaps rightfully, that even the mighty US could face a ‘Liz Truss moment’ at some point in the future.
Goldilocks or market hubris?
If investors are worried about US instability, it is not reflected in asset prices. US stocks had another solid week, and lead the world on a monthly, quarterly and year-to-date basis. Previous outperformance was about resilient US growth, but recent data has shown a noticeable deterioration. This has been interpreted just as confirmation that the Fed will cut rates in September, though, putting markets in a ‘bad news is good news’ mood.
There are problems with this mindset. For starters, US stock returns (and corporate profits) are so highly concentrated on just a handful of mega-tech companies. While these continue to storm ahead for now, conditions are looking less supportive for those stocks. Our market liquidity indicators have turned somewhat weaker (for example Bitcoin is -10% on the week), and there is pressure on the bond term premium (the extra amount borrowers have to pay for long-term debt) to go up, per the fiscal discussion above. These factors tend to put equity valuations under pressure, particularly those that are already ‘expensive’. Even if things do not turn sour for tech, stock market concentration undermines diversification and, in the medium-term, that contradicts accepted long-term investment wisdom.
The ‘bad news is good news’ theme is also inconsistent with what we saw earlier in the year. Back then, the timeline for Fed rate cuts was repeatedly delayed thanks to US economic strength. This was not interpreted as bad because it was clear that it was in reaction to resilient economic growth, and so corporate profits stood to benefit. But even though growth is now clearly slowing, investors seem to think incredible profit growth can continue, only now supported by the prospect of lower rates. That would be the ‘goldilocks environment’ markets always crave, but those expectations could just be hubris. We will have to watch valuations, relative to the unfolding economic progress, closely.