Sovereign International Daily Market Report

What looming Labour majority means for GBP

UK Prime Minister and Conservative Party leader Rishi Sunak shocked markets last month when he unexpectedly called for a general election on 4th July.

We had mentioned our view in our election report in early-May that Sunak would likely wait until deeper into 2024 before calling for a vote. The clear turn for the better in UK economic data has, however, provided the Tories with a surprise window of opportunity. Inflation has continued on its downward trajectory, falling to the Bank of England’s 2% target in May. Britain’s economy is also now growing again, exiting a mild technical recession following solid expansion of 0.6% in Q1.

While Mr Sunak will be hoping that this stronger economic news elicits an increase in voter support for the Conservatives, this will clearly not be enough to shift the balance in the Tories’ favour. Indeed, this year’s election will not be a closely contested affair. Public support for the incumbent Conservative Party has waned significantly since the last election, particularly following the initial allegations surrounding the Partygate scandal in late-2021 and Liz Truss’ mini-budget disaster in September 2022, which triggered a sharp increase in UK government bond yields and mortgage rates.

Labour continues to dominate in the polls

Keir Starmer’s Labour Party continues to boast a commanding advantage in the latest polls, to the point that a Labour majority is seen as a foregone conclusion. According to the latest poll of polls from Politico, Labour are on course to obtain 41% of the overall vote, up from 32% in 2019, while support for the Conservatives has plunged to 21% from 44%.

Analysis from Electoral Calculus now sees a 100% chance that Labour emerges as the largest party and a 95% probability that it obtains more than the 326 seats it needs to form a majority government. According to their predictive models, Labour is on course to obtain 450 seats in the election (up from 202 in 2019), which would be the most for any single party since 1931. The Conservatives, meanwhile, are set to win just 60 seats - an unfathomable 316-seat drop relative to 2019 and the worst performance since they were founded in 1834.

One development, in particular, appears to have made a Labour 'supermajority’ increasingly likely: the jump in support for Nigel Farage’s Reform UK Party, which is now polling at 18% of the popular vote. While this may be insufficient for any more than a handful of Reform candidates to win a seat in the House of Commons (for context, the Liberal Democrats are predicted to win 71 seats despite polling at just 11%), it looks set to syphon some of the right-wing vote away from the Conservatives.

Of course, the pollsters have been wrong in the past (the Tories outperformed by between 7 to 8 percentage points at both the 1992 and 2015 elections), although even an almighty swing at the eleventh hour will unlikely be enough to prevent anything but a very sizable Labour majority.

What could a Labour government mean for the UK economy?

We see Keir Starmer’s Labour government as far closer to the status quo, and a much more market-friendly proposition, than Jeremy Corbyn’s Labour Party would have been had red triumphed over blue in 2019. Market participants appear to be in agreement and seemingly hold the view that any Labour policy changes would have a minimal impact on the UK economy relative to the current regime (Labour’s tax and spending plans are modest in relation to the size of Britain’s GDP). Of the policies set out in the Labour manifesto, we highlight the below as the most noteworthy:

1) Modest tax hikes worth ￡8 billion (0.35% of GDP), including VAT on private schools, a windfall tax on energy, and changes to the non-dom tax system.

2) Mild spending increases worth ￡5 billion (0.2% of GDP), mostly earmarked for the NHS, education and green energy.

Other policies include plans for the construction of new homes, increased border controls and a commitment to NATO.

How FX market could react to the election

Investors abhor uncertainty, and a shift away from the political status quo is historically bearish for the domestic currency. Indeed, the prospect of a return to a Labour government has been greeted negatively by market participants at previous elections. This was particularly notable at the 2019 general election, when investors feared a shift to the extreme-left and the possibility of reckless unfunded spending under Jeremy Corbyn’s party.

This does not appear to be the case this time around. UK assets have been well supported since the election was called - the FTSE 100 continues to print near record highs, while the pound remains the second-best performing currency in the G10 this year (behind only the US dollar) and is trading around its post-Brexit highs in trade-weighted terms. A recent poll conducted by Bloomberg suggested that almost 60% of investors view a Labour victory as the best outcome for the pound, relative to less than 40% for the Tories, with almost half of the respondents viewing a hung parliament as the worst-case scenario.

We think that this shift in the market’s stance towards the Labour Party can be largely attributed to the below:

1) The likelihood of closer UK-EU ties under a Labour government.

2) A clear shift towards the political centre within the Labour Party since 2019.

3) The modest tax hikes proposed in the Labour manifesto, and the lower risk of unfunded spending, even if only due to the limited room for fiscal manoeuvre.

4) Lingering damage done by a perceived mishandling of the UK’s finances by the Conservatives, particularly following Liz Truss’ mini-budget mishap in 2022.

Outlook for GBP under a Labour majority

Given the clear gap in the polls, a majority victory for the Labour Party should be effectively fully priced in by financial markets. That said, we still see the possibility of some mild upside in sterling in the weeks following the election, even if the immediate reaction in GBP to the exit polls and official results is minimal. We think that markets will welcome the prospect of an improvement in relations with the European Union, in particular, while the earlier than anticipated removal of the admittedly mild election risk premium could buoy consumer and business confidence, and offset the downside impact from a summer UK rate cut.

We see the unlikely possibility of a hung parliament, or the more plausible scenario of a weaker-than-expected Labour majority, as somewhat of a tail risk for the pound heading into the vote. Under either scenario, Keir Starmer’s party would have a slightly more challenging task of forcing policy changes through the House of Commons. The forming of a more fragmented than anticipated government could present some near-term downside to sterling in the immediate aftermath of the vote, particularly given current market pricing. This does, however, appear a rather remote possibility.

In the longer-run, Labour will have the arduous task of convincing markets that it has a credible plan to improve the fortunes of the UK economy. UK growth has been weak in the past year, debt levels have increased to six-decade highs and foreign direct investment has fallen. Indeed, the IFS warned this week that the Labour Party would raise taxes rather than cut spending in order to spur growth. This possible swing to more traditionally leftist policies perhaps presents itself as the biggest downside risk to the pound during Keir Starmer’s stay in Number 10.

Britons will head to the polls on Thursday 4th July. Exit polls will be available at 10pm BST, with most results to be known in the early hours of Friday morning.

Market Report provided by Ebury

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