Financial Update from Brewin Dolphin - 21 June 2024

June 2024

Friday 21 June 2024

In his latest weekly round-up, Guy Foster, Chief Strategist, discusses the potential impact of the French election on bond markets, UK interest rate expectations, and strong UK retail data.

Although the markets are still open as I write this, this looks to be another good week for invested assets. Stocks and bonds are generally higher.

The improvement in bond markets follows benign inflationary data released by the U.S. Bureau of Labor Statistics last week. This has firmed investors’ expectations that the next move in interest rates will be down rather than up.

But around that theme there have been differences in bond market performance. At a time when national finances are stretched and there is an unprecedented number of elections taking place, political factors are likely to be important.

Populism and bond turmoil: The French connection

We still have months to go until the U.S. election, but in Europe, voting will be taking place much sooner. The French bond market in particular has been adjusting awkwardly to new political uncertainty.

The poll-leading National Rally party spent the 2022 presidential election pledging to slash VAT on energy, exempt the under-30s from income tax, and allow retirement at the age of 60 for many workers, with only reduced immigration and a clamp-down on fraud as potential means of funding these enormous tax cuts/spending increases.

Also riding high in the polls are the New Popular Front, an alliance of left-wing parties that also advocates a big fiscal expansion. This has seen a rise in French borrowing costs as investors try to discern the likelihood of these policies coming to pass.

Since calling the election, the polls continue to suggest populist parties that have made unrealistic spending pledges will win the largest share of the vote. The historical evidence would suggest they’ll moderate their plans once in office. To be fair, it’s true of almost all parties, whether populist or establishment, that their commitments reflect more wishful thinking than firm policy promises; it’s just that the difference between aspiration and outcome is likely to be far starker with the populists.

Reality check: A French revolution

It’s possible the new French government attempts to enact its fiscal largesse – in which case, we could see a bond market revolt. It might be tempting to call this a repeat of the Liz Truss mini-budget, but even in that instance, the most likely ultimate outcome is a chastened government conducting a policy u-turn.

Ultimately, the Truss government in 2022, the populist Italian coalition government in 2018, and French President Mitterandin 1983 all succumbed to more conventional fiscal policy under pressure from the market.

Is the UK banking on a change?

In the UK, we are a couple of weeks away from the election and the polls continue to favour the Labour party by a historic margin. The government heralded some good economic news this week, as the inflation rate declined and public finances improved.

If you recall, one of the arguments in favour of holding the election early was that there was a very strong chance of an improvement in inflation numbers in this last release before polling day. The prime minister can now demonstrate inflation has returned to target, but he can be less confident about the path of prices thereafter.

Another reason to bring the election forwards was that there was no longer a rationale to wait and deliver more tax cuts in an autumn budget. Does the good news on public finances released today change that? Not really. Although it means the UK is no longer borrowing more than the Office for Budget Responsibility had forecast on a cumulative basis this year – the meaningful fiscal pressure remains. Neither main party seems likely to be able to meet its manifesto commitments without finding new tax revenue after the election due to the unrealistically low departmental spending budgets that have been forecast.

Coming back to the inflation numbers, they showed the inflation rate returning to target. However, much of that’s a reflection of volatile price movements in food and energy, which are considered outside of the Bank of England’s gift to influence.

Core inflation runs at 3.5%, well above target. And the services category, which could be considered to reflect wage inflation, was particularly sharp. Services prices rose by 5.7% over the last year and 0.6% over the last month alone. There was little within this print to justify a cut in interest rates.

Nevertheless, when the Bank of England’s Monetary Policy Committee (MPC) met this week to consider interest rate policy, it clearly felt the case for a cut was building. Two members voted for a cut outright. And the minutes of the meeting reveal a discussion about this troublesome services inflation.

Of the seven remaining members, “some” felt that services inflation indicated that inflationary pressure remains. “Some” is MPC speak for two to three members. It’s distinct, for example, from “several”, which would mean three to four members.

The others were less troubled by services inflation, believing it to be driven by temporary factors like the seasonal increase in the national living wage. These “others” would seem sufficient, if added to the two currently proposing a cut, to reach a majority, and the wisdom of the markets now implies there’s a 60% chance of rates being cut in August.

But if these members feel that way, why are they not cutting now? Clearly, they need to see some further evidence of inflation slowing or the economy weakening between now and then.

A fly in the ointment of the improving inflation story is the persistence of some alternative measures of inflation. We calculate the median monthly inflation move to give a more stable indication of underlying inflationary pressure.

Since 2021, this measure has exceeded the 0.2% that would be consistent with the Bank of England’s inflation target. An improvement in this metric would seem a necessary precondition to inflation staying close to target.

Things can only get better?

In the absence of moderating services inflation, why do people feel comfortable expecting interest rate cuts? Because the economy is slowing. The key evidence for this comes from the labour market, but the data is inconclusive, and key measures like redundancies certainly suggest that employment is not collapsing.

Meanwhile, consumers have been recovering from post-pandemic inflation and are now beginning to increase spending. National Insurance has been cut, which increases their post-tax incomes, and survey evidence suggests consumers have replenished their savings with wages outstripping price growth for a few quarters.

This was reflected in this morning’s retail sales numbers for May, which were quite strong. A combination of better weather than in April, income growth, rebuilt savings and lower goods prices have enticed consumers back to the shops.

Hopefully, nothing happens to upset the improving national mood, but with an election and the European Football Championship taking place over the next fortnight, it could be an emotional time.

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