Things can only get wetter

• High yield UK bonds outperformed the rest of the bond sector, rising +0.1%
• US government bonds ended the week flat in local currency terms

• Equities broadly weakened in sterling terms. Emerging markets slid
  -1.4% and the US -0.5%
• Bonds also sold off broadly, with gilts down -0.6%

Prime Minister Rishi Sunak has ended months of speculation by calling a UK General Election on the 4 July. However, the timing of the announcement, clouded by damp weather, has puzzled many – for some time, polls have suggested that Labour are on course to win a significant majority and Sunak has until January 2025 to call an election. A sizeable election victory would give Labour a reasonable degree of freedom to pursue policy reforms, while a closer run race leading to a narrow majority for Labour could make Keir Starmer more reliant on the left wing of the party.

While we do not yet have manifestos for either major party, Labour has suggested that boosting business confidence in the UK, growing private investment and reforming the labour market will be areas of focus. In aggregate, such policies could modestly raise the potential growth rate of the UK economy, and indeed the pace of GDP growth, but many of these reforms will take time to implement.

While Labour are expected to win a significant working majority, elections can be unpredictable and they would need to win a large number of seats, after major losses in 2019. A hung parliament would require support from the likes of the Liberal Democrats or perhaps the SNP if Labour were to form a government, and would clearly reduce the policy room available.

In reality, the economic implications of the elections are likely to be relatively modest. Firstly, unlike the last election, there is relatively little room between the policy stance of Labour and the Conservatives on economic matters. Secondly, the UK faces a more constrained fiscal backdrop, which leaves limited room for changes to taxation or government spending. This reflects the higher interest burden faced by the Treasury, and the impact of unfavourable demographics on the public purse, as well as greater caution at the Exchequer after the Truss mini-budget bond rout.

Given how consistent polls have been over a number of months, markets are likely pricing in the likelihood of a Labour majority. This is likely modestly positive for GDP growth, and modestly negative for the outlook for public borrowing. Overall, this may see the UK’s credit outlook downgraded modestly, and it could be modestly negative for gilts. Given that there is relatively little to choose between the two major parties’ economic policies, and a Labour majority is likely priced in, any impact on equity markets - which have enjoyed greater support lately – from the outcome of the election may be limited. However, UK equities remain under-owned globally and a shift in broader sentiment due to a less uncertain outlook could support flows back to the UK. 

Market participants had expected last week’s inflation print to be the week’s main event. As expected, the Consumer Prices Index (CPI) measure of inflation dropped sharply, with the year-on-year rate of headline CPI slowing to 2.3% from 3.2%, and core inflation slowing to 3.9% from 4.2%.

Inflation slowed due to the drop in the Ofgem (Office of Gas and Electricity Markets) price cap in April, which helped the housing and utility component to drop by -2.5% in April, as well as past strong increases rolling out of the year-on-year calculation. However, some elements of the basket showed greater resilience. Services prices slowed to 5.9% from 6% prior, remaining elevated. This was supported by firmer travel and communications costs.

Looking ahead, CPI is expected to fall further this year, toughing at around 2% in Q2 and Q3, before rising modestly at year end. However, forecasts have been revised modestly higher, reflecting evidence of greater persistence in services inflation and the expectation that growth will be relatively resilient this year.

For the Bank of England, expectations of a June interest rate cut have faded, given the stronger outlook for inflation and activity. Following the election announcement, the first rate cut is now expected in November. This likely reflects the expectation that a new government may announce some fiscal easing at the front end of the Parliament, though the Bank of England only officially consider announced policy moves, and a Budget cannot take place until September if the Office for Budget Responsibility (OBR) forecasts are to be prepared in advance.

Interest rate cut expectations have also been pared back in the US, with a first cut now priced for December. Last week’s minutes for the May Federal Open Market Committee (FOMC) meeting were published, confirming discomfort at the lack of downward progress for the inflation print, and noting that it will take longer than previously thought to gain sufficient confidence that inflation is converging back to target. However, the minutes also reiterated that rate hikes are not the base case.

While FOMC participants still viewed the current policy stance as restrictive, many expressed uncertainty about how restrictive policy is currently. “Various” participants noted they would be willing to tighten policy further if appropriate. “A few” participants also said they would have been willing to keep quantitative tightening (QT) running at its prior, faster pace.

Since the meeting, a number of members have reiterated a clear preference to remain data-dependent, and economic data has broadly shown signs of cooling in recent weeks. A slowdown in Owner Equivalent Rent could give the FOMC greater confidence that inflation is heading in the right direction.

 

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