The UK election in July 2024 has ushered in a significant shift, with a socialist government taking the reins which for some, will be the first time in their working lives. While the UK represents a modest 3.5% of global stock market capitalisation, the impact of this governmental change on UK-based clients remains substantial, particularly due to their exposure to the gilt market. For financial advisers and investment managers, this change brings new challenges and opportunities.
Labour's Agenda: A Fresh Approach
The King's speech outlined the new Labour government's ambitious agenda, focusing on:
These plans are likely to be funded through a mix of capital growth, GDP expansion and borrowing so the potential for increased capital taxes could present new avenues for financial advisers to explore with their clients.
Economic Challenges and Fiscal Responsibility
The UK economy faces significant hurdles, necessitating a prudent fiscal approach. Interestingly, the bond market's reaction to the election suggests confidence in Labour's commitment to fiscal responsibility. However, achieving sustainable growth remains a key challenge for the new government.
It's worth noting that despite Labour's significant majority, only one in five voters supported the party, highlighting the quirks of the first past-the-post system. The new government appears committed to strengthening the role of the Office for Budget Responsibility (OBR), further emphasising their focus on fiscal prudence.
As the political scene shifts, financial advisers must stay informed about potential policy changes and their implications for investments and client portfolios. This proactive approach will be crucial in providing sound advice in the evolving economic environment.
Growth: The UK's Key Challenge
The UK's economic growth remains a pressing issue. With an ageing population and over 9 million economically inactive individuals, boosting productivity is paramount. While immigration could potentially help, it comes with its own set of costs and political risks.
The UK's debt-to-GDP ratio of 101% is also a cause for concern, as ratios above 100% can be problematic for open economies like the UK as this fiscal constraint limits options for growth strategies.
Despite these challenges, there are modest signs of improvement, namely:
The economy may grow by 0.7%-1% this year, potentially higher next year, but returning to 2.5%-3% growth seems unlikely in the short term.
To boost productivity, supply-side reforms are essential. The government's ambitious plan to build 300,000 houses annually faces historical challenges. Incentivising major house builders could be key to achieving this goal. The taxation system also requires reform, but Labour's approach of potentially taxing capital gains may prove counterproductive for growth.
Long-Term Challenges
Despite a brief honeymoon period, the new government faces significant long-term challenges. Fundamental issues like immigration, population growth and productivity remain unresolved. Supply-side reforms may take years to yield tangible benefits. Improving productivity through targeted training is crucial. Shifting focus from low-value degrees to in-demand skills could be beneficial, but concrete plans are currently lacking.
Economists often view people as economic units, with the UK's inactive population seen as a drain rather than an asset. Increased debt growth and gilt issuance may be necessary, presenting challenges for gilt yields. The upcoming Basel IV banking regulations, requiring banks to hold more government bonds, could provide some support in this area.
There's an irony in the UK's approach to population growth. Industries like agriculture and construction face labour shortages, yet immigration limits are being imposed. This impacts productivity and infrastructure development. The US has benefited from immigration, which has helped keep wage inflation down in blue-collar jobs. The UK could potentially learn from this approach.
Funding Challenges and Tax Reforms
The UK's high debt-to-GDP ratio complicates funding for new projects. While the government is considering tax reforms, such as inheritance tax changes, balancing spending and debt remains a significant challenge. More debt issuance seems likely to fund the King's Speech agenda. The government's financial plans however, face scrutiny, with concerns about a potential £33 billion shortfall. Growth is crucial to avoid tax increases or money printing. The Great British Energy project, costing over £8 billion, poses a challenge for revenue generation.
Market Outlook
Despite these challenges, the UK market appears more attractive than in recent years. It's seen as defensive and undervalued after a period of underperformance. The improvement in political stability has helped to address one of the four factors that have historically held back UK markets:
1. Lack of high-quality growth stocksAs financial advisers navigating this new landscape, staying informed and adaptable will be key to providing valuable guidance to clients in these changing times.
The potential increase in taxes could affect disposable income and spending, possibly slowing economic growth. The UK stock market continues to trade at a discount compared to global markets, partly due to its sector makeup and shortage of growth companies. The UK stock market struggles to attract listings and maintain its global market share. This creates a tricky situation, as changes to listing rules may not be enough to compete with the allure of US listings.
CFOs are likely to suggest US listings to their boards, given the higher multiples. The US market trades at about 21-22 times earnings, while the UK trades at 9-10 times.
Despite lacking big tech and AI firms, the UK market offers solid companies with sensible profits and good dividend flows. These firms tend to be defensive, making the UK an attractive option for portfolio building. The UK market's focus is limited to banking, pharmaceuticals, oils and miners. However, many UK-listed companies earn significant revenue from overseas, reducing the impact of domestic economic factors.
Active management in the UK market could potentially yield better results by looking beyond the main market and capitalisation-led approach. Despite challenges, the UK market remains a key part of diversified portfolios, offering value and income opportunities for investors willing to dig deeper.
The US market heavily influences economic forecasts. The S&P 500 has seen strong returns, driven by a handful of tech stocks. Earnings growth is crucial for index performance, with current expectations at 17%. US equities are arguably priced to perfection, with a price-to-earnings ratio of about 20. Any earnings slip could introduce market volatility, as seen recently with ASML's earnings report and concerns about Trump's stance on tech giants.
Europe has implemented rate cuts to combat recessionary pressures, with the ECB acting ahead of the US Federal Reserve. Switzerland, Sweden, Canada, and Mexico have also cut rates. Japan remains an appealing market, with new economic policies allowing bond yields to rise and encouraging domestic investment. The weakened yen has boosted Japanese exporters.
In the US tech sector, NVIDIA has seen remarkable growth, with its market cap surpassing entire national stock markets. Other 'Magnificent 7' stocks have performed well, except for Tesla's challenging year. The S&P 500's health has broadened, with various sectors trading above the 200-day moving average. Utilities, consumer discretionaries and small caps have shown notable growth, with the Russell 2000 up over 11% in the week post-election. This indicates growing confidence in the US economy.
Inflation Trends
US inflation is declining, as shown by the Federal Reserve's Beige Book. Producers are once again competing on price, suggesting a healthier inflationary outlook. However, reaching the 2% target may take time, with inflation plateauing just above this level and the potential return of Donald Trump to the White House could lead to stickier inflation. Producer price inflation has decreased from its peak but remains at reasonable levels.
Market expectations for interest rate cuts have been tempered. Earlier forecasts predicted US rates at 4% and UK rates at 3.9% by now, but no moves have occurred in either country, with only a 25-basis point cut in Europe. This slower approach to rate cuts may be seen as more prudent by central banks.
The Federal Reserve faces a delicate balance. Cutting rates too quickly could signal economic weakness, potentially impacting stock markets negatively. Conversely, maintaining high rates for too long risks economic slowdown and rising unemployment.
The market anticipates a potential 'Trump trade' following the US election in November. Bond markets are responding, with short-dated bonds yielding less and longer-dated bonds yielding more, suggesting a normalising yield curve after years of inversion. This steepening indicates higher future inflation expectations.
The Federal Reserve Open Markets Committee is expected to hold rates at 5.25-5.5% in the near term, with a high probability of the first rate cut in September. This is significant for both bond and equity markets.
The US economy's debt accumulation has accelerated dramatically, now reaching $1 trillion every 90 days. The debt refinancing cycle, coinciding with business and presidential election cycles, requires liquidity injection to prevent market seizures. This liquidity tends to boost real asset prices, including equities and property.
The business cycle, as indicated by the Institute of Supply Management, is expected to trough and then peak in about a year, another positive sign for real assets.
US Election Year and Market Trends
Historically, the S&P 500 has shown positive performance in 80% of election years. Current polls indicate a strong lead for Donald Trump, potentially leading to increased onshoring, stricter immigration policies, and heightened tariffs against China.
Earlier this year, we capitalised on overweight positions. We reduced our Asia-Pacific and Chinese exposure whilst recalibrating our fixed income towards shorter-term yields, which has proven beneficial. Our US allocation has increased to approximately 30%, a position we're comfortable with given the ongoing liquidity and positive momentum. It's noteworthy that there have been no volatility corridor breaches, and all advised risk levels remain stable.
Trump's recent Bloomberg interview reiterated his focus on tariffs. While some worry about the inflationary impact, it's crucial to consider that increased spending in one area often leads to reduced spending elsewhere, potentially balancing inflationary effects. Trump's comments on a weaker dollar may have more significant implications for inflation and interest rate cuts.
The dollar's strength has largely mirrored interest rate differentials, particularly evident against the yen. As interest rates decrease, the longer-term trajectory for the dollar is expected to weaken.
Trump's stance on delaying rate cuts until after the election appears to be more about taking credit than economic necessity, raising questions about the Fed's independence and potential political interference in monetary policy decisions.
UK Inflation Challenges
In the UK, the service sector and wage inflation have been key factors in maintaining economic stickiness. The discussion explored the potential impact of a headline rate within tolerance and a 5% service sector or wage inflation level.
Increased spending power without pressure on interest rates could be beneficial. However, the public sector's influence on wage inflation, particularly with a Labour government supported by unions, presents challenges.
The Bank of England's leadership, including Andrew Bailey and Hugh Pill, are perceived as hawkish, potentially holding rates steady until September or later. The conversation highlighted the difficulty in achieving the 2% inflation target, with current wage growth at 5.7% needing to decrease to around 3%.
Long-term Outlook
While short-term improvements are possible, the yield curve is expected to normalise and become upward-steepening. Long-term interest rates in the 4-5% range were suggested as potentially normal, particularly for the US, given ongoing inflation concerns.