Written by Peder Beck-Friis, Economist at PIMCO
The Labour Party’s election win, in which it secured a large majority, means it can govern with considerable freedom.
The result was widely expected and, as such, we see limited implications for markets. As Labour’s fiscal agenda is modest, with a focus on delivering economic stability, there should also be limited implications for the economy.
This has parallels with Labour’s first term following its 1997 election victory, when the new Tony Blair government – with Gordon Brown as chancellor – tightened fiscal policy and focused on establishing credibility.
We expect the new government under Keir Starmer to maintain tight fiscal policies. This should facilitate a gradual decline in inflation and enable the Bank of England (BoE) to begin cutting interest rates soon – and potentially cut more than markets expect next year. Therefore, we believe UK government bonds (gilts) are attractive at current levels.
Policy constrained
The election result could affect the economy in two key areas: by influencing economic demand through fiscal policies, and improving long-term growth through supply-side policies.
On the demand side, Labour’s intended fiscal policies are modest. By 2028, the party plans slightly higher spending, worth around 0.3% of current GDP[1], which will be balanced by equivalent tax increases, keeping the deficit broadly unchanged. This fiscal approach should have minimal impact on growth and inflation, especially given the broader uncertainties around economic growth.
While policy intentions may change, any new measures will be limited by tight fiscal space. Labour plans to keep the current fiscal rules broadly intact, and it has close to zero fiscal headroom when it comes to the most binding rule: that debt must fall as a proportion of GDP in five years. While these rules could be amended to free up more fiscal space, the government is unlikely to make drastic changes in the light of the financial and fiscal volatility seen after the 2022 Liz Truss budget. Any additional spending will likely be funded by higher taxes, but this too is limited by a tax burden that is already at a post-World War II high.
Taken together, we expect fiscal policy to remain tight in the coming years, with the deficit gradually decreasing. Although Labour’s new policies are neutral for the deficit, they follow existing tightening measures announced by the previous government, which imply real-term cuts to spending and higher real-term taxation via tax threshold freezes. We see limited room for Labour to significantly deviate from this path.
The productivity conundrum
Instead of stimulating demand, Labour will likely focus on improving supply and long-term growth. The recovery since the pandemic has been sluggish. While there may be some mean-reversion ahead – indeed, momentum has picked up since the start of the year – we doubt the new policies will meaningfully change the long-term trajectory. In any case, growth policies take some time to filter through into higher activity.
Productivity growth in the U.K. has been declining for decades, more so than in many other developed countries. Improving productivity is a challenge, not least because the causes of this secular decline are not entirely clear. A softer stance towards the European Union (EU) might marginally improve growth prospects, but it is uncertain how much the EU would cooperate. More industrial policies may help specific sectors but are unlikely to boost overall economic activity.
The U.K. has also lagged in investment spending, partly due to a low savings rate and strict planning restrictions that limit construction. Recently, weaker economic activity also reflects a fall in the growth in the supply of workers, despite record immigration, as many people have left the workforce due to long-term sickness. Unlike in almost all developed markets, the labour force participation rate is now below its pre-pandemic level. New policies in these areas could boost future growth, and the next year will be a good test of how serious the new government is about addressing long-term challenges.
Investment implications
Financial markets haven’t reacted much to the election result, which is unsurprising given it was so widely expected. Indeed, markets are more focused on growth, inflation, and monetary policy.
While overall U.K. inflation is now back to its target of 2% year-over-year[2], core inflation remains high at 3.5% year-over-year. We expect core inflation to continue falling, as inflation expectations are anchored, the labour market has gradually eased, and fiscal policy remains tight.
We expect the BoE will start cutting rates soon, possibly at the next meeting in August. Going forward, financial markets expect the BoE to cut interest rates broadly in line with the U.S. Federal Reserve. However, we see potential for faster cuts in the U.K. due to low growth and tight fiscal policies.
Given this, we believe gilts are currently trading at attractive levels, especially compared with U.S. Treasuries. Across the curve, we continue to believe intermediate rates are the sweet spot for taking interest rate exposures.
