Financial Update from Brewin Dolphin - 24 May 2024

May 2024

The Weekly Round-up

Friday 24 May 2024

In his latest weekly round-up, Guy Foster, Chief Strategist, discusses the economic rationale for a July UK general election, the dividing lines between the Conservative Party and Labour, and fresh global economic data.

The event which seemingly caught the world off guard this week was the announcement of a UK general election, which will be held on 4 July. The papers on Thursday morning were rife with stories of cabinet members being kept in the dark, and many asked why an election would be called now when the party lags so dramatically in the polls.

Theoretically, an election could have been held as late as next January, but that would have required campaigning over Christmas (which is not something voters would have appreciated). The working assumption had been that the election would take place in November.

Last month, I questioned that assumption:

“…an established preference exists to not have elections coinciding amongst members of the so-called Five Eyes intelligence collaboration alliance (driven by the U.S.

and UK and incorporating Canada, Australia and New Zealand). The perception is that a change of power in these countries can complicate their responses to signals intelligence. The UK and U.S. electoral systems tend to mean complete changes in the executive government, rather than the evolving coalitions seen in other countries, which heightens the risk.”

So, there lies a political, or at least non-economic, reason not to have the election in November. Was it meaningful? It hasn’t been cited as such; instead, the decision is rumoured to have been made after the local elections, which were predictably terrible for the Conservatives, but perhaps not decisively great for Labour.

The economic rationale for a July election

Economic motivations seem clearer. The most obvious reason for calling a July election is the inflation rate announced yesterday morning.

The figures showed a relatively sharp decline in the inflation rate, from 3.2% to 2.3%. This bookends a period in which the UK, which suffered unfortunately high inflation rates for many months, has seen a significant improvement in inflation figures (it peaked at more than 11% in late 2022 and was still nearly 9% a year ago).

The so-called base effect drove the decline in inflation that caused the apparent slow down. This was therefore more a reflection of last April’s price increases dropping out of the numbers than this April’s price increases being particularly low.

To a lesser extent, the same thing will happen next month, providing a continuing narrative of lower inflation as we approach election day. The controversy is what happens after that, because the strength of services inflation in Wednesday’s report might cause prime minister Rishi Sunak to worry about lingering inflationary pressure, like that seen in the U.S. this year.

My preferred measure for underlying inflationary pressure is the monthly change in median prices, which has been picking up recently.

The other reason I suggested last month for thinking an earlier election might be on the cards was public finances, which were worse than the Office for Budget Responsibility (OBR) predicted at the Spring budget:

“…these latest data suggest UK finances are getting tight. There will be little point in holding a fiscal event if there is no scope for further tax cuts. If forecasts are excessively optimistic, the risk is that fiscal policy might need to be tightened, a politically unpalatable prospect both parties are hoping to postpone until after the election.”

Another month’s public finance figures were announced on Wednesday. Although they were overshadowed by theinflation news, and then the election announcement itself, they have deteriorated again, and OBR forecasts will need to take account of compensation payments due in respect to the NHS contaminated blood scandal as these become sufficiently certain.

The scope for tax cuts is therefore falling. Meanwhile, growth is relatively good for now, bouncing back from a technical recession in the second half of 2023. Unemployment is relatively low, but jobs growth has been slowing, so there is more scope for joblessness to rise than decline.

So, overall, the economic backdrop for a 2024 election might not get much better than this.

While the rationale for an early election may exist, it doesn’t mean the government will prevail. Indeed, according to polling and election forecasters, a substantial Labour majority seems virtually inevitable.

Both parties will be working on their manifestos, and the changing state of public finances will complicate their efforts, but what do we know about their differences and what do they hope to change?

The dividing lines between the Conservatives and Labour

Labour has proposed several solutions to boost the British economy, including planning reform, better EU relations, the Green Prosperity Plan, and strengthening workers’ rights. It aims to increase funding for the NHS, schools, childcare, policing, and border security. To finance these initiatives, Labour plans to crack down on tax evasion, increase the energy tax levy, reform the non-domicile tax regime, abolish the carried interest loophole, and charge VAT on private school fees.

Labour also pledges to keep corporation tax at 25% and maintain current income and capital gains tax rates.

Labour’s Rachel Reeves aims to balance the budget and strengthen the OBR’s role. However, given the high government interest expenses, the deficit is expected to remain significant, with UK debt potentially rising to 300% of GDP by 2070. Concerns about government finances will persist for policymakers.

When the manifestos are written, likely in two or three weeks, they will be scored by the Institute for Fiscal Studies. It’s common for them both to err on the side of generosity. It’s likely that the gap may be particularly wide this year, and particularly so for Labour.

The Conservative Party has made life awkward for them with popular tax cuts and defence spending commitments, which Labour will have to reverse if it doesn’t want to limit its own initiatives. So far, it has suggested it will keep these commitments.

Since the announcement

Rishi Sunak’s election campaigning has been greatly hindered by the weather. As well as his campaign launch speech, it has also impacted economic statistics. If the prime minister was looking for April’s retail sales to fit the narrative of an improving economy, he’ll be disappointed. Consumers bought around 3% less in April this year than they did last year. Why? Probably because it was the sixth wettest April since 1836, with 55% more rainfall than average and about 20% less sunshine. Not a great shopping month.

Assuming some normalisation in weather patterns, some catch-up spending would see May and June recover some of that lost activity, which could give an impression of economic momentum as we approach election day.

Could there be more sinister weakness lurking behind the weather effects? Consumer confidence seems to have improved over the month, and based on the best data we can access, it seems even with a slowdown in employment growth, aggregate real wage growth is expanding.

Away from the UK

Provisional data for economic performance in May comes from the purchasing managers indices. They show that the UK economy continues to perform ok. Admittedly, the service sector seems to have slowed down markedly during May, but even that slower pace reflects a still-healthy expansion.

Globally, the services expansion still seems to have good momentum. Crucially, the U.S. bounced back with its strongest services business growth in a year.

Services activity has been expanding far faster than manufacturing, where companies have had to work through inventories built up after strong lockdown-driven demand for durable goods. We are hopeful that the fourth quarter of 2023 marked the low for manufacturing, and the latest data support the expectation of a continued, if slow, recovery.

The other familiar theme we’ve discussed in these notes is our preference for semiconductors. and Nvidia was among the last companies reporting this earnings season, issuing probably the most anticipated earnings release this quarter.

Nvidia is a good example of the real-world economic beneficiaries of the revolution in digitisation and artificial intelligence. Its valuation seems high, but its financial performance is stunning. A year ago, it made $7bn of revenue; the equivalent quarter just reported saw that rise to $26bn. Profits have increased from $2bn to nearly $15bn.

The observation that the U.S. equity market price earnings ratio is at the upper end of its historic range is a fair one, but it has to be seen in the context of the extraordinary companies that have come to dominate the market.

A simple price earnings ratio does not take account of the different pace of growth or reliability of earnings constituents may have. It partly reflects profit margins, but does not demonstrate the remarkable profitability of some members.

There has never been a time when such large companies have been able to grow profits at such an extraordinary pace. That is not to say that all members of the so-called Magnificent Seven are unambiguously positive, but excluding any of them based upon a crude measure of earnings multiples would be unwise.

The value of investments can fall and you may get back less than you invested. Neither simulated nor actual past performance are reliable indicators of future performance. Performance is quoted before charges which will reduce illustrated performance. Investment values may increase or decrease as a result of currency fluctuations. Information is provided only as an example and is not a recommendation to pursue a particular strategy. Information contained in this document is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. Forecasts are not a reliable indicator of future performance.