Log inMarket Update – Is it really change, or simply the perception of change? – from Jilly Mann
In this update I shall explain how I expect the Labour victory in the UK General Election to impact investment markets. Does their election slogan of ‘Change’, really mean change? I also cover events overseas, where perhaps change is certainly happening, albeit not necessarily for the better.
- The UK General Election result
- Potential policy changes
- Tax changes afoot
- How UK equities may benefit from a Labour Government
- Maybe the UK isn’t the worst place to be?
- The prospects for bonds
- Impact on pensions
- Conclusion
The UK General Election result
As expected, the Labour party won the UK General Election with a significant majority. The Tory vote disintegrated amidst infighting and pressure from the resurgent Liberal Democrats and a disruptive Reform party. In my view the result of the election supports the need to reform the political voting system in the United Kingdom. Labour secured two thirds of the seats up for grabs, but with only one third of the total votes cast.
The first past the post electoral system in the UK often throws up these seemingly disproportionate results and is grist to the mill for those advocating a potentially fairer electoral system. Proportional Representation being the path increasingly touted as a better solution to make more votes count. I personally have thought for some time that UK politics does require some sort of reform and that better outcomes for voters would be achieved by better utilising the talent and experience across all parties, albeit under the auspices of a Prime Minister and majority party. It may even abate the Punch & Judy politics we are too often subjected to. Even with a slogan of ‘Change’ and a large majority, the Labour party will be operating under the constraints of the UK debt burden. Continuing to juggle the extremes with his own party under increased scrutiny, may not prove much easier for Keir Starmer, than it proved for the Tories in later years.
Potential policy changes
It wasn’t easy to write too much about the impact of a Labour Government ahead of the election, because they weren’t overwhelming us with policy detail. Now in power, we await detail of how they may turn some of their ideas into reality, but I think the biggest message that markets take from Labour coming to power is that there may now actually be a period of stability, not drastic change. Quite ironic really.
The impact of the Liz Truss Premiership still haunts Downing Street. Jeremy Hunt as Chancellor of the Exchequer had to take a sensible approach to fiscal policy as he picked up the pieces from the disastrous Kwarsi Kwarteng September 2022 mini-Budget, now Rachel Reeves will need to do the same in her role as Chancellor. The last thing Labour want to do is anything radically Truss-esque in the first 12-18 months, so although I think there will be some headline-grabbing quick wins on the cards, there will be nothing that will fundamentally impact mass swathes of the UK population. Depending upon how the first couple of years go, that isn’t to say that harder-hitting policy won’t come later.
Labour haven’t yet announced the date of their first Budget, but I wouldn’t expect them to rush it through. I would expect them to want to appear to be cautious in announcing a date, having given themselves time to get a better understanding of the fiscal options available to them.
Tax changes afoot
Labour have already stated that they won’t be increasing income tax or National Insurance. What they may mean though is that they also don’t increase the personal allowance thresholds, which have become the stealthy way to increase the tax take. If incomes rise each year, but the tax bands don’t, more people move through the tax brackets and end up filling the Treasury’s coffers.
Capital Gains Tax (CGT) is an area where I would expect change, but not necessarily as a broad-brush policy shift. To raise CGT levels across the board could actually stifle growth. Labour’s success is going to be based on a growing economy, which actually isn’t hugely dissimilar to Truss’s objective, which will likely coincide conveniently with the Bank of England cutting interest rates.
I’m aware that I have tried to forecast when interest rates will fall for some time and each time, the Bank of England have held firm. Sentiment is now shifting within the Bank and it would surprise me if we didn’t see the Bank of England cut rates at their next meeting in August, failing that, they will need to follow the ECB’s lead in cutting rates at the subsequent meeting. They simply cannot hold out much longer with inflation falling. We have been waiting for the impact of interest rate rises to really show in the economic data. For some unique reasons, it has taken longer than normal for the data to show weakness, but we are seeing weakness coming through much more swiftly. It would be mighty useful for Keir Starmer to see the Bank of England commence an interest rate cutting cycle at the advent of his tenure in Number 10, albeit the Bank of England is not meant to be a political animal.
Once we see the Bank of England commence the rate cutting cycle, we think it will be tentative to start with, perhaps a quarter of a per cent cut, but then we will likely see an acceleration in cuts, faster than is being forecast, until we reach a level of around 2.5-3% as a Base Rate. I wouldn’t be surprised to see rates stick there for the foreseeable future if inflation remains stable.
Why the combination of interest rates and CGT rates matter, is because interest rate cuts should stimulate growth in the economy. CGT rates rising could stifle growth, if business owners are put off from selling their businesses by punitive tax rates. The Government need investment into UK companies, the British ISA policy from the former Government being a fledgling idea for that. Investors may be put off if they will ultimately be hit with too high a tax rate for investing and realising assets here, compared to elsewhere. I would expect CGT to rise, but in certain sectors initially.
The UK has a housing deficit. Labour have pledged to build 300,000 new homes each year and overhaul the planning rules to enable this. They will need to throw out rather than overhaul current planning rules to come close to achieving such levels in this country and so whilst I expect those numbers to revise down, one way they can increase the UK housing stock is by increasing taxes on second homeowners and landlords.
The previous Government had already changed the taxation system for buy to let owners and I wouldn’t be surprised to see Labour go further and perhaps use CGT as a means of increasing the tax take, whilst encouraging property owners to release property back onto the market by selling down portfolios ahead of any potential change in legislation. To encourage buyers for those properties, interest rates and in turn mortgage rates need to fall, but if Labour benefit from a perfect storm, then it is feasible to see this change being introduced.
Increasing council tax so that higher value properties pay commensurately higher council tax is another relatively easy policy change that could be implemented.
There hasn’t been much clarity with regard to potential inheritance tax changes, but there has been talk of revisions to the residential nil rate band thresholds. This would be another swipe at homeowners, especially those with higher value properties.
There was talk during the election campaign that Labour could introduce a property tax so that a CGT-like tax was applied to the sale of all primary residences. I would be surprised if this was brought in as a policy in the near term, as it would impact too much of the electorate and the feelgood factor for a new Government could quickly be eroded by such a policy. That is why I think we will see change to aspects of legislation, but in those areas which will be popular with Labour’s traditional core vote, rather than anything which would be too controversial.
How UK equities may benefit from a Labour Government
We have been increasing our allocation to UK equities in recent months. We have written before about the huge undervaluation of the UK market against the US and many global peers. If we were to look at returns year to date and compare the Magnificent Seven US stocks which continue to prop up the US market with UK stocks, the top performer by some margin is Nvidia. Coming in second and third are NatWest and Barclays, two UK FTSE 100 stocks.
The chart above shows the performance of NatWest stocks in dark green, Barclays in red and the FTSE 100 in lime green since the start of the year. The headlines don’t talk about the recovery of some of these stalwart UK stocks. Seemingly, all of the narrative has to be about how awful the UK economy is doing and how fantastic the US economy is. The truth is somewhat different. We would rather be investing in stocks which aren’t being spoken about yet, so we can benefit from the early stages of their recovery, than chase the last legs of a very concentrated stock market rally which is struggling to even extend to 7 stocks in the US.
We are well placed to benefit from future Labour Government policy through our UK fund exposure. The JO Hambro UK Equity Income fund has 10% of holdings directly linked to UK housing market activity levels. 8% of this figure equates to manufacturers of products that go into houses (e.g. brick producers) and retail that is geared to housing (DFS, Wickes). Every stock in the 8% has the potential to more than double in value given their starting valuation in the manager’s view.
The move to net zero by 2030 was a highly contentious campaigning point and again I doubt whether Labour’s targets will be achieved, but they will be compelled to try. Electricity Grid is targeted to be carbon neutral by 2030. To achieve that, stocks such as DRAX and Centrica, are key, these are stocks which are owned by the JO Hambro fund.
Finally, I touched on prisons in our last update, but Keir Starmer has announced James Timpson, CEO of the Timpson Group, as the new minister for Prisons, Parole and Probation, despite not being an elected MP. James Timpson has a long record of recruiting ex-prisoners into his key cutting and shoe repair business and he has a track record of working with prisons on rehabilitation programs. This expertise bodes well for some practical guidance on how to not only reform the prison system but build enough prisons with the right resources to encourage prisoners not to reoffend. The JO Hambro fund has exposure to those companies tasked with building prisons in the UK.
I refer to the JO Hambro fund as an example, but the reason why we increased our UK equity exposure is not because we don’t believe that bonds are the right place to maintain an overweight exposure to, but because we identified specific opportunities in the UK equity market which we felt were being ignored by most investors. The advent of a Labour Government will be beneficial to the areas of the market which we are exposed to and so we would hope that forthcoming policy announcements encourage further investment into these areas of the UK market.
Maybe the UK isn’t the worst place to be?
Whilst the UK has relatively quietly gone about the General Election, France has been at quite the opposite end of the spectrum. In the continuing tide towards extremism in Europe, France is the latest to veer that way. The EU is just about managing Hungary, with their more extreme Government, how the EU manages a much more influential country in the form of France, with no overall majority and infighting between the extreme right and extreme left, remains to be seen. National Rally were formed by Jean-Marie Le Pen in 1972 and were formerly known as the National Front. Today, they are led by Jordan Bardella and whilst the National Front no longer want to leave the EU or the Euro, their goal is to weaken the EU from within.
The election process in France involves two rounds of voting. National Rally took the majority in the first round but were relegated to 3rd place in the second round on the 7th July 2024. The latest result means President Macron will have to deal with a coalition of the hard left (the New Popular Front) which is led by France’s more extreme version of Jeremy Corbyn, Jean-Luc Mélenchon.
Macron would remain President until the 2027 election, presiding over defence and foreign policy, but Mélenchon could become Prime Minister in charge of domestic affairs.
The French stock market has not reacted well to this snap election, which has seemingly backfired on President Macron. The chart below shows the FTSE 100 in green versus the Euronext France CAC 40 in blue since Macron called the election on the 10th June 2024.
The turmoil of the arrival of the National Rally and a resurgence of the hard left in the French corridors of power won’t go unnoticed. If the UK think they are getting change with Labour, we maybe ought to look across the Channel and see what change really means.
One would think that the US election should be less interesting given that we know both candidates and we have seen markets react to both in the past. In essence, I wouldn’t expect stock markets to react extremely to either a Republican or Democrat win, but the fly in the ointment could be who actually is the Democrat candidate.
As we often say, markets like certainty. At the moment the election will be won on the basis of ‘anyone but Trump’ rather than any particular party allegiance should the Democrats triumph. As President Biden continues to flounder, the markets will have uncertainty even if he beats Trump in the polls. Nobody can doubt that there is no longevity in Joe Biden and so one could assume that there would need to be a change of leadership in the White House almost immediately.
Reports are that leading Democrat figures want to make that change now. There is no single figure who is leading the way to unseat Joe Biden, but with Kamala Harris, currently Vice President, seemingly not the default successor, a selection of senators are starting to come to the fore as potential candidates. With some high-profile independent candidates also running for President, Robert F Kennedy Jr amongst them, the US election has focal points which surround personality and fitness to govern, rather than perhaps the bigger issues of the day, such as the Middle East, Russia, North Korea and Iran.
From here, it would appear that the US are going to see change in a real sense, which again gives the UK a relative air of calm middle-ground, at least for as long as Keir Starmer can keep his party on that track. With uncertainty in other areas of the globe, perhaps a period of stability in the UK will lead to people deciding that investing in the UK isn’t the worst decision they could make.
In terms of our portfolios, we are overweight the UK, have reduced our exposure to the US and are monitoring our exposure to Europe and Emerging Markets. Our Asian allocation has been a consistent performer and has benefitted from being focused on the Australasia, India and Taiwan regions.
The prospects for bonds
We remain overweight bonds and despite taking advantage of a tactical opportunity in UK equities, remain steadfast in our belief that we are yet to see the best of the bond market. The last month has been an interesting litmus test. For the first time in a while, the UK 10 year Gilt yield and the US 10 year Treasury yield have both moved sidewards, but we have seen bond funds produce positive returns. Why this matters is because a sidewards movement in Gilts and Treasuries would often result in bond funds also moving sidewards or moving down based on sentiment. Bond yields in our portfolios are typically over 5% at the moment, in many instances this also equates to a risk-free return. i.e. a return being generated by a Government backed risk-free asset.
The comparison above shows the US Treasury 10 year yield compared to the UK 10 year Gilt yield year to date. They follow a similar path, which will only be broken if one of either the Bank of England or the Federal Reserve cut rates at a different time to the other. Our expectation is for the Bank of England to move first.
Our bond exposure has only around 3% exposure to high yield assets. High yield assets are those which are lower in quality and therefore potentially higher risk in terms of their ability to return the original capital payment to investors on maturity. High yield assets should in turn offer much higher yields to investors to compensate them for the increased risk. It is not unusual to see them paying yields of over 7% to investors. The problem is that the underlying bond value fluctuates wildly and the yield may still not compensate for the underlying valuation falling. We are deliberately positioned away from high yield, because we think that as economic data worsens, especially in the US, we will see increased default rates in this area of the market.
We are seeing plenty of data coming out of the US, which highlights worrying spikes in unemployment data and falling Purchasing Managers’ Indices (PMI) that are suggestive of a recession deeper than the bullish soft-landing rhetoric of 2024 would have you believe. PMI is a measure of the prevailing direction of economic trends in manufacturing. When that number breaches a certain level, it is often deemed evidence of a recessionary environment.
Our bond exposure is also heavily weighted towards the UK, US and Europe. The European Central Bank have already started to cut interest rates. As I mentioned earlier, I expect the Bank of England to follow suit in the next couple of months and I would expect the Federal Reserve in the US to do so before the end of the year. The Federal Reserve are now in an awkward position in that they are resolutely looking at a couple of very specific pieces of data as their trigger to cut, in spite of all other evidence suggesting that they should go sooner. They are also now in the heart of the election season and so whilst they are meant to be apolitical, with the sorry state of the US Presidential election battle, anything of practical impact on the US consumer which the Federal Reserve do now, will be leapt on by both parties.
The Liontrust Sustainable Bond managers were with us a couple of weeks ago and their base case for the potential upside in bonds from either a maintenance of the status quo, or a cut in interest rates continues. As we inch closer to the Bank of England rate cut announcement, we expect the bond market to rally ahead of the official announcement. We are well positioned to benefit from that rally from the outset. To not be invested in bonds to the extent which we are, we think would be illogical when the upside is a matter of when, not if. When the rally happens, it will be swift and we will be looking to take those gains and rotate into other areas of the market, where we expect to see similar types of recovery gains.
Impact on pensions
It would seem remiss to conclude this report without commenting on what a Labour Government may mean for pensions. It is a topic that many clients are asking us about and the simple answer is that we just don’t know at the moment.
During the election campaign, there has been a U-turn from Labour on reintroducing the Lifetime Allowance, but I would urge caution on any manifesto pronouncements as they are pure speculation and maybe don’t mean never, just not immediately.
It is highly likely that Labour do change the tax relief rates for pension contributions. Rachel Reeves lobbied for a 33% top rate of tax relief on pension contributions a few years ago and maybe that is the thin end of the wedge so to speak, as to where tax reliefs may end up.
Speculation around the removal or change to tax free lump sums from pensions also abounds. At the moment, we have heard nothing that suggests this is imminent. Any significant change such as that, would require transitional rules to compensate individuals who have been planning to draw lump sums in retirement. The pension world loves nothing better than a new set of transitional rules to fathom, but as it stands now, it is business as usual.
The state pension is catching up with the tax-free personal allowance threshold and if the personal allowance isn’t raised, then many pensioners may find themselves paying tax on previously untaxed state pensions. How Labour address or choose to ignore that remains to be seen.
Limiting the amount that individuals can pay into pensions is something that would be relatively simple to introduce, as it has been played about with for years by various Governments. The one thing that the Government need to be mindful of is that they need individuals to make their own provision for retirement. The state cannot afford to fund the numbers of people heading to retirement or extended life expectancies. The Government also has to walk the tightrope for public sector workers who could be caught by taxation on pensions that would cause them to leave the industry early.
I listed some potential tax changes that we may see from this Government earlier, but these remain speculation not fact. Labour are seemingly on a mission to make some easy wins by increasing tax on those they deem to be the wealthiest to appease their core vote. The problem with pensions and the current income tax thresholds, is that many more people will be caught by widespread changes to contribution limits and tax reliefs than would have been the case under previous Labour Governments. I expect changes to pension legislation, but whether they will be in a position to announce much during the remainder of this tax year remains to be seen. I wouldn’t be surprised to see them consolidate support this year and announce more intricate changes such as those applying to pensions in future tax years.
Conclusion
Now is an exciting time for portfolio management. Change is happening to a greater or lesser extent. Change in interest rates is positive for our portfolios. The cautious change of the Labour Government is a positive for UK equity markets and in turn our overweight positioning to UK equities. The disruptive change in Europe is a reminder as to why we are selective with our wider equity allocation, favouring bonds over equities. The uncertain change in the US creates a somewhat stagnant economic environment at best, but one which is propped up by 7 stocks, 6 of which aren’t even the best performing stocks in the world year to date.
The last few years have been a frustrating period for portfolios, but we should be careful what we wish for. Cautious, stable change that brings consistency is not a far cry from our objectives when managing investment portfolios. The alternative is attractive and may often make for an easier message to clients, but if it doesn’t feel sustainable, or is too prone to change in the extreme, it simply doesn’t feel like the right course to follow on behalf of our investors.