UK Election Special - Shifting to the Left
Bill O'Neill, Gary Dugan, Chadi Farah, Mohammad Iravani
The Global CIO Office
- The UK electorate has dramatically ended 14 years of Conservative Party rule with a crushing victory for the Labour Party, winning a majority of 166 with 408 seats.
- Conservative Party representation falls to 136, 208 seats lost and its worst defeat in modern times.
- Voter turnout was depressed with the swing to Labour modest given the haul of seats gained
- Sir Keir Starmer, the new Prime Minister, will lead a strikingly different cabinet in terms of background and policy priorities; more left wing that the Blair government.
- Stability to be emphasised and austerity to be avoided.
- Taxes are likely to rise, particularly on capital and non-earned income. Higher tax burden will be blunted by higher borrowing short term at least.
- Crucial challenge is to raise sustainable growth requiring radical action and reform.
Labour’s triumphant victory comes after one of the most dismal and uninspiring campaigns in a generation. Both main parties avoided addressing key challenges such as the state of public finances and effective immigration policy, with the approach itself described as a ‘conspiracy of silence’. The pre-election manifestos were structured on a safety-first basis to avoid any political fallout from too radical proposals. Labour’s net spending commitment amounted to 0.4% of GDP, equivalent to a weekend’s worth of output, as the ex-chief economist of the Bank of England put it.
Daunting Challenges Ahead
- Weak Productivity: Average GDP growth of 1.1% per annum since 2008. GDP per head has grown by only 7% since 2010 with an inactive population of 2.8 million.
- High Tax Burden: The highest tax burden in 70 years is set to rise further with tax bands frozen despite the reduction in national insurance charges.
- Public Debt: Public debt burden is close to 100% of GDP post-COVID-19 and Ukraine energy shocks.
- Deep Budget Cuts: Implausibly deep cuts in non-protected spending are already embedded in budget projections over the next 5 years.
- Threadbare Public Services: Symbolized by extended NHS waiting lists, overcrowded prisons, and a defense commitment that will have to be up-scaled.
Macro Management: The Chancellor Needs to Get the Basics Right
The election will have little impact on Bank of England monetary policy. The new Chancellor (almost certainly Rachel Reeves) is unlikely to change the Bank’s inflation mandate. The Monetary Policy Committee is expected to start cutting rates from the current 5.25% in August in response to weaker wage growth and lower service price inflation. A firmer sterling, in reaction to Labour’s decisive victory, might give more assurance around an August cut.
Rachel Reeves aims to avoid a repeat of the mini-budget catastrophe under Liz Truss in 2022 and has committed to entrench the role of the Office of Budget Responsibility (OBR) to maintain policy credibility. In her first budget, slated for September, she will stick to the previous government’s medium-term fiscal strategy, targeting a reduction in borrowing in the last year of the 5-year plan with borrowing only for investment purposes.
Official Projections for UK Economy
This still leaves open the possibility of modestly higher borrowing in the early years, especially on public investment projects, including the so-called Green Budget if growth disappoints in the new term of office. Nonetheless, the Labour cabinet will be very alert to any threat to its fiscal credibility.
To address a radical reshaping of Whitehall, the new Government is planning a set of five mission boards empowered to cut across ministries to meet specific policy targets around the NHS, planning, and devolution. Clearly, the relationship between Chancellor Reeves and No. 10 Downing Street will be crucial in delivery.
A New Age of Austerity Looks Implausible and Deeply Damaging
Having criticized the Tory party for the state of public services, the new government will see any drift toward austerity as damaging to its long-term prospects. For instance, pressure to eliminate the two-child cap on family income credit will be intense and immediate. Far from additional cuts in the face of disappointing tax revenue flows, holding the line with the outgoing government’s fiscal projections of 4% per annum real cuts in non-protected areas outside NHS and social care seems unlikely. The Institute of Fiscal Studies estimates that an additional £30 billion will be needed just to maintain existing spending levels in volume terms.
There are areas where the Treasury can innovate, such as altering the accounting of QE losses by the Bank of England, and of course, the debt service burden may undershoot as rates are cut, but any windfall will be limited. Estimates suggest every one percentage point decline in average interest costs of debt saves £12 billion.
Higher Growth: A Potential Medium-Term Benefit but No Immediate Silver Bullet
Raising trend GDP growth looks very much like the holy grail for this government, beset by limited alternative options. A rising tax revenue base would support spending commitments while keeping fiscal sustainability on track. However, any potential upside surprise on growth in the next three years looks limited. True, the economy is now growing again, led by consumption, but the OBR is already at the optimistic end of the consensus with a prediction of 1.8% growth in GDP as against the consensus at 1.5%. Lower inflation is a double-edged sword for government finances given slower nominal growth that results.
The real challenge is to lift growth through radical steps around building approval and planning reform, English regional devolution, and incentivizing long-term pension fund risk-taking. Building activity would respond well to a push back against NIMBYism and a more actively engaged local/regional authority in terms of the cost of building up a land bank.
Read My Lips – Taxes Will Inevitably Rise
One virtual certainty is that taxes will rise further under the new government. Labour’s manifesto already laid out modest levies on private school fees, private equity carried interest, and closing further non-domicile tax loopholes. There is also a proposed stamp duty on purchases of residential property by non-UK residents.
Revenue-raising targets amount to a modest £7.5 billion. Clearly, there is more in the pipeline.
Labour has committed not to raise income tax, national insurance, and VAT rates in its first term. Nonetheless, clear signals indicate that higher taxes on non-earned income and assets are in scope. These include:
– Capital Gains Tax Reform: Equalizing rates paid with that of income tax, estimated to raise £17 billion if enacted.
– Private Pension Reform: Reviewing the 25% tax-free allowance on crystallized benefits.
– Council Tax Review: Reviewing local council tax bands to raise revenues.
Calm Reaction to Labour Victory
The market reaction to Labour’s victory appears muted but generally positive. Sterling has proved stable overnight, and the gilts market should react calmly given the incoming government’s emphasis on credibility and confidence in fiscal policy management. Thursday saw a rise in the FTSE100 in anticipation of a stable single-party Labour victory with a significant majority, even if from the centre-left of the spectrum.
Tax policy will be a focus for investors, especially around capital gains and private equity tax treatment. Supporting fundraising activity and IPOs across the UK stock market will be areas of interest.
The UK equity markets have become less relevant to global asset allocators as their market value has dropped below that of leading US tech stocks. However, the country should continue to perform solidly as it has in recent weeks.
If it was just about the political complexion of the country, the social democrat leadership in the UK would be a sharp contrast with the potential outcomes in France (this weekend) and the United States.
Sterling’s positive performance in overnight trading provided the best reflection of the change of guard in the UK. Sterling has generally traded at around the same level against the dollar over the past six months.
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