Interest Rates and Elections

Holding Strategy

The Monetary Policy Committee (MPC) of the Bank of England met on Thursday (14 December) and, as expected, held the UK base rate firm at 5.25 percent where it has remained since August. Not a single MPC member voted for a cut; though three members wanted to increase rates, as was the case at the November meeting. However, The Bank warned the markets not to expect rate cuts anytime soon. Monetary policy, it said, needed to remain “restrictive” for a further extended period. Sterling rose to nearly $1.28 after the decision, up by 1.6 percent on the previous day.

Sterling’s strength arises because an interest rate differential between sterling and US dollar rates is thought likely to open up. Further to a meeting on Wednesday, the Federal Reserve had signalled that dollar rates were likely to start coming down next year, given that core inflation in the USA is down to 3.1 percent. Its projections suggested three rate cuts were likely next year. The New York equity markets responded positively.

Last month, prime minister Sunak announced that he had succeeded in his goal of halving UK inflation over the course of the year. Inflation is down from nearly eleven percent in early January to 4.6 percent at the end of October, which is the latest figure available. Except that the control of inflation is in the gift of the central bank which runs monetary policy – interest rates and money printing – independently from the Treasury, which is run by the Chancellor of the Exchequer. So, it is a bit rich for the prime minister and the Chancellor to take credit for reducing inflation.

The popular wisdom is that rates have already peaked, or at least plateaued, on both sides of the Atlantic and that it will be, given a little breathing time, downhill from hereon in. That is why a lot of investors, institutional and retail, are getting excited about bonds which will rise in price as interest rates fall.

The Bank of England has raised rates 15 times since December 2021 when the inflationary tsunami hit our shores – even before the Russia-Ukraine war began. Interest rate rises take time to feed through into the real economy; and the impact of the most recent rate rise on 28 July is probably still in process. But how long will it take for inflation to subside to the Bank’s official target rate of two percent? The financial markets in the form of Gilt futures seem to be sanguine that there will be three 25 basis point cuts from the middle of next year, in which case the base rate would end 2024 at 4.5 percent. HSBC even thinks that the base rate could be down to 3.75 percent by the end of 2025.

That would be good news for mortgage holders, many of whom have traditionally been Tory voters. Back in July, the average rate for a two-year mortgage deal was 6.86 percent; but since then, rates have eased. Last Friday (08 December) the average two-year mortgage offer fell below six percent for the first time since the spring, according to Moneyfacts Compare. Just to put this into perspective, as late as December 2021 a two-year fixed rate deal could be had for around two percent. On the other hand, there are around five million British homeowners who must yet remortgage at higher rates over the next three years, the Bank estimates.

All this makes a case for Rishi Sunak to delay the upcoming UK general election until the autumn, and not to call it on 02 May when the local council elections will be held across England, as well as the London mayoral election – as I speculated here a week ago. For a general election to coincide with the local elections, parliament would have to be dissolved by 20 March at the latest. That would mean that the Spring Budget would have to take place in the first week of March, if not earlier, for the Finance Bill to receive royal assent before dissolution. The political developments of the last week, however, with the Tory Party returning to factional infighting – this time over the Rwanda policy – beg the question of whether Mr Sunak’s government will survive until next autumn. Meanwhile, the public clamour for a spring election is growing.

One main reason why inflation has eased is that energy prices have fallen. Despite the upward pressure on oil and gas prices at the outset of the Russia-Ukraine war, prices are stable this winter. And fears that the oil price would soar as the Israel-Hamas war escalated have turned out to be the dog that did not bark. Even though OPEC has threatened to reduce oil production, the fall in demand from China has had a mitigating effect. Brent crude was trading at $76.71 on Thursday evening and unleaded petrol was available at UK forecourts at just above the £1.40 a litre mark in London.

On Tuesday (12 December) we learnt that UK wage inflation had eased even as job vacancies were down. Wages rose by an annualised 7.3 percent between August and October, down from 7.9 percent in the summer – but still much higher than in the USA or the eurozone. That means that wages are rising faster than inflation and therefore wages are increasing in real terms. Job vacancies have fallen for 17 months in a row. The level of unemployment remained unchanged at 4.2 percent. This data bolstered confidence further that rates might be cut next year.

Then, on Wednesday, we got the latest growth data. Britain’s economy shrank more than expected. GDP contracted by 0.3 percent in October, according to the initial estimate by the ONS. Analysts had expected a contraction of 0.1 percent. Output was down across the manufacturing, construction and services sectors. This was the ninth recorded contraction in the last 24 months. This means that Britain is teetering on the edge of recession on the eve of an election year. And yet, on the plus side, UK exports appear to be bearing up, reaching £876.6 billion in the year to the end of September – a rise of 11.1 percent on the previous year’s figure.

Christine Lagarde, president of the European Central Bank, also took a hawkish line on inflation on Thursday, suggesting that investor bets on interest-rate reductions, as reflected in the futures markets, may be premature in the eurozone. “We should absolutely not lower our guard. We did not discuss rate cuts at all,” she told reporters after the ECB left interest rates unchanged at 4 percent. Core inflation in the eurozone is down to 3.6 percent but Madame Lagarde expressed fears that there is a risk that inflation could reignite across Europe in the near term.

The dilemma for central banks is that if they leave rates too high for too long they throttle the economy; but if they cut them too soon they allow inflation to persist or to intensify. The USA seems to be in a sweet spot where the outlook is benign; Europe and the UK remain in more trepidatious territory. This is largely due to the USA being self-sufficient in energy, while Europe is a major importer of hydrocarbons.

The City Prepares For Labour

The City and UK big business are preparing for a Labour government. This is to be expected as a change of government in the UK next year now looks inevitable, with a poll published on Thursday afternoon showing Labour on 43 percent and the Conservatives on 26 percent – a 17 point margin. It is not entirely surprising then that Labour’s high command including Sir Keir Starmer and Rachel Reeves have been plied with Chablis and smoked salmon of late by City supremos anxious to ingratiate themselves.

Labour’s business conference scheduled for next February sold out in just a few hours. On Thursday last week (07 December) the Labour Party revealed the names of ten Square Mile grandees who form a panel put together by the Shadow Chancellor to advise the party on financial services. The panel includes Sir Douglas Flint, the former chairman of HSBC who now chairs Abrdn (formerly Aberdeen); David Schwimmer, the chief executive of the London Stock Exchange Group, and Sir John Kingman, chairman of Legal & General. Moreover, a survey conducted by Bloomberg last September found that two thirds of money managers and traders believed a Labour government would be the “most market friendly outcome” at the next election.

Over the last few months, Blackrock’s Larry Fink has praised Sir Keir Starmer as offering hope to British politics, while ex-Bank of England Governor Mark Carney, who is now the Chair of Brookfield Asset Management, has endorsed Ms Reeves as a competent Chancellor-in-waiting. Richard Walker, the boss of supermarket chain Iceland, declared that he could no longer support the Conservative party as a business leader, adding that many lifelong Tories he knows now “find it hard to disagree that the country is in a considerably worse state than it was when their party returned to power”.

Furthermore, Labour is attracting big-ticket donations such as the £3 million from Lord David Sainsbury, the former chairman of the supermarket chain, and more than £500,000 from Gary Lubner, the former boss of Autoglass.

But there are also concerns. The fear is that Labour will make dismissal of underperforming employees more difficult – that is, more litigious. It will rein in the gig economy and extend “workers’ rights”. That would reduce the degree of labour market flexibility for which the UK was once admired. The Resolution Foundation – one of Labour’s favourite think-tanks – has already outlined plans for huge increases in capital gains tax. That would deter capital formation. “Green energy” would be favoured for new investment under Labour regardless of the projected returns.

One of the reasons why City types are moving towards Labour is that they have an instinct to back winners. They are also totally fed up with a Conservative government which has adopted de facto a policy of tax and spend. In 2019 the Labour Party under Jeremy Corbyn was totally unelectable; but Sir Keir Starmer, assisted by Rachel Reeves, has cleansed the Augean stables.

There were many supporters of Brexit in the City, but few would now tell you that Brexit has bolstered the status of the Square Mile. On the contrary, the London stock market is shrinking fast, even as the Paris market grows. The number of applications to list on the London market, at 56, was the lowest this year for six years. Some international companies like TUI are de-listing, just as Ryanair and Irish building materials giant CRH did.

In hindsight, no one during the 2016 referendum campaign offered a comprehensive cost-benefit analysis of Brexit. The Brexiteers talked much about sovereignty (such as the ability to control how many people enter this country – which seems ironic now); and the Remainers banged the drum of international cooperation. The referendum was called because David Cameron concluded that it was the best ruse with which to dish the United Kingdom Independence Party (UKIP – remember them) which came top in the May 2014 elections for the European parliament. Let it be noted that the Lib-Dems, then in coalition, also voted in favour of holding a referendum.

If the Brexit referendum was an attempt to lance the boil of Euroscepticism on the Tory Party’s face, it has not succeeded. Each Tory leader since the Brexit referendum has, in his or her own way, been cursed. The rumour mill this week suggested that a faction of Tories want to back a leadership “dream ticket” of Boris Johnson with Nigel Farage. This is entirely impracticable – not least because neither man is a member of parliament – and, frankly, absurd. The ticket might excite a minority of Tory Party activists, but it would repel many more British voters than it delighted. The very idea is indicative of how far the party of Churchill and Thatcher has fallen.

Labour, or at least Starmer and Reeves, claims that growth will be the new government’s priority. But how will they achieve it? That is the elephant in the manifesto. If growth remains stagnant, as is regrettably the most likely outcome for the foreseeable future unless there is a change in the national mojo, then Labour will have to match its spending ambitions with increased taxes.

That will render UK PLC less attractive and there will be further upward pressure on bond yields. Labour will blame the Tories – with some justification – for the debt burden which is driving debt service costs to over ten percent of expenditure. But blame will not solve the problem. The reality is that Labour will inherit an economy far less robust than that bequeathed to Tony Blair and Gordon Brown in 1997. The incoming Labour government will have little room to manoeuvre – especially if inflation persists above target.

There are, however, reasons why a Labour victory might yet be a cause of satisfaction for “small C” conservatives. First, only Labour stands a chance of giving the SNP a bloody nose in Scotland. If Labour could win 20 or so seats north of the border that would put Scottish first minister Hamza Yussuf back in his box. Second, Labour will re-set our relationship with Europe, which can only be a good thing.

Who knows, Sir Keir might even persuade Emmanuel Macron to stop selling inflatable dinghies to known people traffickers and modern slavers at the Boulogne outlet of Décathlon. Now that really would be something.