Recent local election results in which the ruling Conservative Party suffered severe losses have reinforced the view that the Labour Party will form the next government. In last month’s article we looked at what a Labour government might mean for business conditions in the UK. In this month’s article we explore some of the possible implications of a future Labour government for investors in UK bond and equity markets.
Macro stability and the bond market
In our article of April 2024, we noted that the Labour party under its current leader, Kier Starmer, has changed dramatically in recent years and has become considerably more business friendly. After the economic turbulence of the last decade, resulting firstly from the decision to leave the EU and secondly from the ill-fated mini-budget of 2022, Starmer and his shadow Chancellor, Rachel Reeves, have promised a period of economic and political stability.
At its most basic level, this will involve making policy predictable, thereby giving market participants the confidence to take longer-term investment decisions. As regards monetary policy, Reeves has indicated that the independence of the Bank of England will be guaranteed under a future Labour government, and the 2% inflation target will be maintained1. Given ongoing speculation that central banks could come under pressure to raise their inflation targets (see our commentary of March 2023) and the growing risk of political interference in monetary policy due to rising debt levels, Reeves’ commitment is potentially significant.
The continued pursuit of low and stable inflation will be particularly important for investors in UK government bonds. If the Bank of England were to lose its independence and/or the inflation target were raised, this would likely result in an increase in inflation expectations which would raise bond yields and (given the inverse relationship between a bond’s yield and its price) result in capital losses.
Investors in UK fixed income markets should also welcome Labour’s prioritisation of ‘financial responsibility’. Labour has clearly learnt the lessons from the disastrous mini-budget of September 2022, when then Chancellor Kwasi Kwarteng announced a series of unfunded tax cuts which unnerved financial markets and sent Gilt yields soaring. Reeve’s pledge to stick to the current government’s fiscal rules and her reassurance that any significant tax and spending changes will, by law, be subject to independent analysis and forecasts from the Office for Budget Responsibility (OBR, the independent fiscal watchdog) should mean that a ‘self-inflicted’ spike in bond yields is not repeated.
Of course, it is impossible to say precisely what will happen to interest rates and bond yields under a future Labour government. However, the Labour party is at least making all the right noises to reassure bond investors. This said, Labour will be under acute pressure to deliver improved public services, and the dubious assumptions on which current OBR deficit forecasts are based (implausible spending plans and politically-unpopular increases in fuel duty) mean that it will be difficult for Labour to avoid a deterioration in the public finances. The ratings agency S&P has warned that UK debt is at risk of a credit rating downgrade after the election, a development that could potentially put upward pressure on UK Gilt yields2.
Government policy and the equity market
The implications of a Labour government for investors in UK equities are likely to be somewhat more nuanced. Investors have traditionally been wary of Labour governments, but, as we noted in April, the party under Starmer has shifted to the centre ground in recent years.
It is true that the UK equity market has tended to fare better under Conservative governments. Since 1983, the FTSE All-Share index has delivered an average annual gain of 4.9% under Conservative governments, compared with 3.9% under Labour3.
However, we should be wary of overstating the impact that individual governments have on stock market performance. The influence of global market trends and monetary policy often outweighs domestic political factors. For example, the UK stock market fell by around 19% during the 2007-2010 Labour government of Prime Minister Gordon Brown. However, this was primarily due to the fallout from the global financial crisis, for which the government of the time could hardly be blamed. Indeed, during this period, equity markets in the US and the eurozone suffered bigger declines in local currency terms, of 23% and 40% respectively.
After the turbulence brought about by Brexit and the short-lived government of Liz Truss, the prospect of a period of relative economic and political stability, along with improved relations with the European Union, could improve sentiment towards UK equities, which have been somewhat unloved by investors in recent years. A Bloomberg survey conducted in September 2023 showed that 64% of professional investors thought that either a clear Labour victory, or a Labour-led coalition would be the most ‘market-friendly’ outcome of the forthcoming election. Only 25% thought that a clear Conservative re-election would be best for financial markets4.
Sector-specific impacts
However, the prospect of a more interventionist government worries some observers, and given the sectoral impacts of Labour’s policy announcements, there are likely to be winners and losers. Take the possible winners first. Starmer has said that Labour will be the party “of the builders not the blockers” and will aim to deliver the “biggest boost to affordable housing for a generation”. If it happens, this will be good news for homebuilders operating at the lower end of the housing market, and will also benefit companies that supply building materials.
Companies operating in the renewable energy sector could also benefit under Labour. Labour plans to decarbonise the electricity grid and deliver 100% clean power by 2030. And although the party has dropped its promise to invest £28bn a year under the “Green Prosperity Plan”, it still intends to spend an extra £4.7bn a year over and above the £10bn of green investment already announced by the current government. In addition, extra spending will also be forthcoming from a £7.3bn national wealth fund, as well as from a proposed publicly-owned clean energy company, to be known as Great British Energy5.
However, with Labour planning to partially fund its green investment plans with an expansion of the current windfall tax on oil and gas companies, the conventional energy sector is expected to face headwinds under a Starmer-led government. Labour intends to increase the so-called Energy Profits Levy to 78% from its current 75%, while also reducing tax reliefs and extending the duration of the tax by two years to 20296. In addition, Starmer has also said that a future Labour government would not issue any new oil and gas extraction licences.
The Labour Party under Starmer has rowed back on the pledge of his predecessor, Jeremy Corbyn, to nationalize energy firms, the water companies, and Royal Mail7. However, in April, the party confirmed that it would take most passenger rail services back into public ownership, by not renewing existing contracts with private companies when they expire8. Shares in Firstgroup, the UK’s largest rail operator, have struggled in the wake of the announcement, and can be expected to underperform if Labour wins the election and follows through with its plans. Similarly, investors in Trainline, which provides centralised train booking services, have been spooked by Labour’s pledge to simplify the rail ticketing system, a development that could hit the company’s revenues9.
As regards the banking sector, lenders would presumably welcome a period of stability that Labour might bring. However, there are concerns that the banks could become a target for a cash-strapped Starmer government. In particular, there has been speculation that the government might oversee a reduction in the interest paid on commercial banks’ deposits held with the Bank of England. These deposits have grown as a result of the various bouts of quantitative easing (QE, or buying bonds) that have taken place since the financial crisis. As interest rates have risen, the income commercial banks receive on reserves has become increasingly significant10. Some estimates suggest that cutting interest paid to the banks could boost the government’s finances by around £1.5 billion11.
Finally, Labour’s plans to increase the minimum wage, and also take the cost of living into consideration when setting its level, could be a source of margin pressure for companies employing large numbers of low-paid workers. Firms in the retail and hospitality sectors could be vulnerable in this regard.
A positive catalyst?
There is still a lack of detail on Labour’s policy proposals, and Starmer has gained a reputation for policy U-turns12. However, on the evidence so far, it is doubtful that a Labour government would turn investors off UK equity and bond markets, and some elements of policy will be welcomed. The Labour Party under Keir Starmer is a very different beast to the party of Jeremy Corbyn, which struck fear into financial markets five years ago.
Undoubtedly, some firms will face a more challenging environment under Labour. However, factors beyond domestic politics play a large, if not greater, role in driving UK equity markets. Given that markets are forward looking and a Labour government after the election seems all but assured, it is significant that the UK index of 100 leading shares has hit successive all-time highs in recent weeks13; investors do not appear to be worried.
Even after the recent strong performance of UK large caps, they are still relatively lowly valued. The forward price/earnings ratio for the UK market stands at just 11.6 versus 20.9 in the US and 13.2 for the eurozone14. Taking differences in sector composition into account, the UK trades at a discount of around 30% versus the US market15. If a change of government acts as a catalyst for improved sentiment towards UK equity markets, there would appear to be plenty of catch-up potential.
14th May 2024
1 https://labour.org.uk/updates/press-releases/rachel-reeves-mais-lecture/
2 https://www.reuters.com/world/uk/next-uk-government-faces-credit-rating-challenge-sp-says-2024-04-04/
3 https://www.standard.co.uk/business/stock-market-tory-labour-conservative-prime-ministers-governments-truss-election-sunak-starmer-b1149098.html
4 https://www.bloomberg.com/news/articles/2023-09-17/bloomberg-poll-labour-led-government-will-be-best-for-uk-markets-investors-say?sref=QJEHVNWR
5 https://www.theguardian.com/politics/2024/feb/08/labour-cuts-28bn-green-investment-pledge-by-half
6 https://www.ft.com/content/0d1326b7-8c83-46bc-a9c2-56ce7bb1a109
7 https://inews.co.uk/news/politics/labour-reverses-pledge-nationalise-energy-water-mail-general-election-2194125
8 https://www.bbc.co.uk/news/uk-politics-68889345
9 https://uk.finance.yahoo.com/news/trainline-firstgroup-shares-tumble-labour-130034472.html
10 https://committees.parliament.uk/committee/158/treasury-committee/news/201204/major-banks-report-135-increase-in-income-from-bank-of-england-reserves/
11 https://www.bloomberg.com/news/articles/2024-04-26/ubs-says-investors-fear-labour-could-hit-uk-banks-boe-deposits?srnd=undefined&sref=QJEHVNWR
12 https://www.politico.eu/article/keir-starmer-labour-party-uk-election-u-turns/
13 https://www.londonstockexchange.com/indices/ftse-100
14 JP Morgan - Global Developed Markets Strategy Dashboard – 7th May 2024
15 JP Morgan – Equity Strategy: May Chartbook – 7th May 2024