Economic Commentary - Political risk eases in the UK, but rises in the EU and US

Political risk eases in the UK, but rises in the EU and US

In this month’s commentary our Chief Economist, Colin Warren, explores the notion that the UK could become a global ‘safe-haven’ as political and fiscal risks rise in the EU and the US.

The term “beacon of stability” is not one that would ordinarily be associated with the UK, given the economic and political turmoil the country has faced in recent years. However, with elections round the world throwing up surprising results, and the political temperature set to rise across the Atlantic ahead of the US presidential election in November, it is one that is looking increasingly apt. Unlike in France, where the recent election has resulted in a hung parliament, the UK has, much as expected, seen a smooth transition to a majority Labour government under Prime Minister Keir Starmer.

Moreover, despite the pre-election fear-mongering regarding the potential consequences of a Labour ‘super majority’ (Labour won 411 seats, compared to the Conservatives’ 121¹ the market reaction to the UK election result has been muted. In the wake of the election, the pound has strengthened slightly on the foreign exchanges² and the 10-year UK government bond yield has been stable around 4.1%³, with little discernible change in spreads versus the US 10-year note⁴. In the equity market, the more domestically-focused mid-cap market has outperformed its large-cap peer, with construction companies posting solid gains in response to the new government’s plans to reform the planning system⁵.

It is early days yet, and as we discussed in our commentary of June 2024⁶, the government faces considerable economic challenges. A key crunch point will be the government’s first budget, which is expected in the autumn. In the absence of a marked improvement in growth prospects, there is a high probability that the Chancellor Rachel Reeves will have to announce additional spending cuts or tax increases if the government is to comply with its primary fiscal rule of seeing debt/GDP fall by the final year of the OBR’s 5-year forecast.

Starmer has said there will be ‘no return to austerity’ under Labour, and has also ruled out hikes to income tax, national insurance, and VAT (which together make up around 75% of total tax revenues). It seems likely that marginal tax hikes beyond those already outlined in the manifesto will be forthcoming, possibly regarding capital gains tax and/or inheritance tax.

However, it would also not be surprising to see Reeves tweak the fiscal rules to provide more wiggle room, possibly by changing the definition of public debt to allow for more investment. The experience of the Truss/Kwarteng mini-budget of September 2022 suggests the government will have to tread carefully in this regard. However, anecdotal evidence suggests that revised fiscal rules which facilitate increased borrowing for investment purposes, and which are signed off by the Office for Budget Responsibility (OBR, the independent fiscal watchdog), are unlikely to see Gilt yields rise much⁷.

Indeed, given Labour’s solid majority and its determination to establish a reputation for responsible policymaking, the prospects for fiscal consolidation in the UK look markedly better than in France or the US, given the political outlooks there.

Policy paralysis in France

The hung parliament that resulted from the second round of voting in the French legislative election on 7^th July seems set to result in a period of policy paralysis. Sure enough, tactical voting meant that the worst outcome for financial stability and European cohesion – a victory for the hard-right National Rally (RN) – was avoided. However, since neither the left-wing New Popular Front (NFP) nor President Macron’s centrist Ensemble group secured enough votes to govern alone, and policy differences make a coalition nearly impossible, an extended period of political uncertainty appears likely.

The parliamentary arithmetic is complex, but political analysts indicate that several government permutations are possible. The NFP, which gained the most seats in parliament, could form a minority government. Alternatively, a centrist grand coalition might emerge, if Ensemble can bring on board moderates from the NFP (e.g. the Socialists and the Greens) and others. If no government can be formed, a technocrat-led government might be appointed to carry out essential legislation, such as passing the annual budget.

None of these options are likely to be particularly stable and capable of tackling the difficult policy issues that France faces. On the contrary, the NFP, which is the biggest grouping in parliament, wants to reverse Macron’s pension reform (which increased the retirement age from 62 to 64), while also raising the minimum wage by around 14%, and increasing public spending.

Fiscal woes

All of this comes at a time when France’s public finances are in a parlous state and the country is under pressure from the European Commission to comply with EU debt and deficit rules (which have recently been reintroduced following their suspension during the pandemic). The French budget deficit has been above the EU’s 3% of GDP threshold since 2020 and stood at 5.5% of GDP in 2023. Moreover, the country’s public debt stood at 110.6% of GDP in 2023, nearly double the 60% of GDP EU limit. In the absence of corrective measures, public debt will rise to a whopping 139% of GDP by 2034, according to the Commission’s latest forecasts⁸.

Gridlock in parliament not only means that deficit reduction measures are unlikely to be passed, but the related political uncertainty could also weigh on the growth outlook, which would further worsen the public finances. Several measures of business and consumer confidence have dipped since President Macron called the snap election in June⁹.

Higher debt servicing costs could also be a problem. The yield on the 10-yr French government bond jumped after Macron called the snap election back in June, taking the spread over the German 10-yr to a 7-yr high of 80 basis points. With the far-right defeated and investor worries easing somewhat, the French-German spread has eased back to 65 basis points, but this is still higher than the average of around 40bps that prevailed during the five years prior to the election being called¹⁰.

Without a government that has the political will and parliamentary backing to impose budget cuts, there is a risk that French spreads could move higher. In May, S&P cut France's sovereign debt rating to "AA-" from "AA", citing the rising debt trajectory and doubts about the government’s ability to continue implementing policies that increase economic growth potential and address budgetary imbalances¹¹. Since the election, another ratings agency, Moody’s, has said the result is negative for the country's credit rating, as it will be difficult for a coalition government to bring debt under control¹². Further ratings downgrades could potentially put further upward pressure on French yields.  

Broader EU implications

The hung parliament in France could also have broader implications for the EU. France’s sustained deviation from the EU’s deficit and debt limits could challenge the effectiveness and enforcement of the EU’s fiscal rules, leading to broader questions about governance in the Eurozone. If the deterioration in French public finances goes unchallenged, it would increase the risk of fiscal slippage in other member states, and undermine the EU’s ability to maintain fiscal discipline and stability.

Political instability in France could also delay key reforms at the EU level, particularly those requiring strong leadership and coordination from major member states like France. Making further progress in a range of areas where France traditionally plays a leading role (including the internal market, capital markets union, and banking union) is now likely to be more difficult.

Moreover, although the far-right have been denied in the recent parliamentary election, there is a growing risk that its eurosceptic leader, Marine Le Pen, will win the presidential election in 2027. Le Pen has run for president three times already and her share of the vote has grown each time¹³. Macron cannot stand for a third term, and if the success of the ‘republican front’ (where parties and voters unite to block the hard-right) is not repeated in 2027, the RN’s accession to power will merely have been postponed and not stopped.

Trump policy risk

Investors are also likely to focus on increased political risk in the US during the coming months. Following the assassination attempt on Donald Trump, and the poor performance of President Joe Biden in the first presidential debate, a second Trump term is looking increasingly likely. Betting markets currently see Trump as the strong favourite to win November’s election¹⁴. Importantly from a policy perspective, recent events have also raised the prospect of a so-called ‘red wave’, where the Republicans secure a majority in both the House of Representatives and the Senate. 

Such a scenario would increase the chances that Trump’s policy agenda – including tax cuts, increased tariffs, and a clampdown on immigration, see our commentary of February 2024¹⁵ - will be enacted. These policies could increase inflationary pressures and further raise the budget deficit at a time when investors are starting to fret about the outlook for US public finances. According to the non-partisan Congressional Budget Office (CBO), the US budget deficit will rise to 7% of GDP in 2024 (up 27% compared with its last projection in February) and, even without further fiscal easing, the country’s public debt pile is on course to reach a record high of 122% of GDP by 2024, vs 99% currently¹⁶.

Although the US dollar’s role as a reserve currency suggests a full-blown fiscal crisis is unlikely, it would not be surprising to see some upward pressure on US bond yields in the wake of a Trump victory in November, as inflation expectations rise and concerns mount over an increased supply of bonds coming to market.

A global safe-haven?

Of course, it is early days and a lot can happen during the coming months. The result of the US election is not a done deal, and in France, a government might emerge that oversees continued reform and budget cuts. However, as it stands, the direction of travel points to a relatively stable, fiscally-responsible government here in the UK at a time when concerns over policy and fiscal sustainability are likely to come to the fore in the EU and the US.

In September 2022, when both the Pound and UK government bonds were sold off in response to the disastrous Truss/Kwarteng mini-budget, the notion that the UK could become a global ‘safe-haven’ would have seemed absurd. Now, not so much.

16^th July 2024