One year of Labour: City's patience fades as bond market signals damning verdict

Daily Mail​

2 days ago

Labour swept to power exactly a year ago armed with a sizeable majority and pledge to revive an increasingly frail British economy.
Prime Minister Keir Starmer, Chancellor Rachel Reeves and cabinet colleagues immediately launched a City charm offensive in the wake of their July 2024 victory, hoping to persuade businesses and investors to back Labour's economic strategy.
But while many appeared cautiously optimistic after several years of uncertainty under multiple Tory leaders, patience is rapidly wearing thin.
Economic growth remains tepid, business and consumer confidence are increasingly weak, and UK inflation expectations continue to surpass those of global peers.
The watering down of welfare reform and the winter fuel allowance U-turn, while welcomed by activists, has eroded the policy certainty associated with a large parliamentary majority and damaged hopes Labour can get a grip of an increasingly fragile fiscal position.
And while Reeves appears to have the Prime Minister's confidence for now, the market response to this week's dramatic PMQs demonstrates market anxiety over Britain's ability to get its house in order.
Higher employer national insurance contributions and a living wage hike since April have only exacerbated the dilemma, with higher labour costs simultaneously weighing on economic output while ramping-up broader inflation.
The result has been to see double-digit increases in longer-term gilt yields – the interest on government debt – with 10- and 30-year yields up 36 and 67 basis points, respectively, over the last year.
There is also now a huge gap between the yield on UK government bonds compared to global peers.
Market veteran Michael Browne, currently an investment strategist at Franklin Templeton, told This is Money: 'The markets are telling you that there is a persistent inflation concern in the UK, which is approximately two-to-three times that of Germany.
'It's telling you there is a lack of confidence in the bond market at the moment about our inflationary position.'
Playing a tough hand
While Labour's complaints of a 'fiscal blackhole' left by the Tories appear to have been met with limited sympathy among media and voters, market participants are aware the UK's economic woes are not a new phenomenon.
'[Labour inherited] a debt-to-GDP ratio of 95 per cent, rising interest rate costs occurring in a period where growth rates were extremely poor and were likely to remain pretty poor,' said Browne.
'Inflation was also running at 3.5 to 4 per cent, so the Bank of England were never going to cut rates very much to help you out.'
He notes Labour have yet to 'disrupt markets' since coming to power, 'especially relative to some of their recent predecessors'.
Browne also praised 'really sensible' efforts to separate day-to-day spending from capital expenditure, and adjustments to the Government's fiscal rules to allow for headroom earmarked for capital projects spending.
Similarly, chief economist at Panmure Liberum Simon French said governing an advanced economy 'with an ageing population, underinvested infrastructure, fiscal liabilities designed under more favourable cost of capital conditions… and almost 20 years of sluggish productivity growth is not an easy task'.
'Overlay this with a generational shift in defence spending and threats of unprecedented international trade disruption and that task begins to look insurmountable,' he added.
French also noted UK GDP is still 'closely tracking' the G7 median since the election, up 0.8 per cent on a compound basis over the three quarters of available data, despite an economic slowdown being a common symptom of a 'change election'.
He said: 'A slowdown in activity as the private sector responds to a new regulatory and taxation counterparty, and as the public sector reprofile their activity to new ministerial priorities, is the experience of previous UK change elections in 1979, 1997 and 2010.'
The deterioration of the geopolitical environment, as well as the imposition of damaging trade tariffs, have not helped.
However, French scores Labour's economic track record as 'a modest six-out-of-10 – clear room for improvement'.
'That score acknowledges the context of a challenging domestic and international backdrop, soft economic trends that were entrenched pre-election, but also some own goals,' he said.
Labour's job tax hikes weigh
The Consumer Price Index was at 3.4 per cent for the 12 months to May, according to the most recent Office for National Statistics data.
Though this was down from 3.5 per cent the previous month, CPI is not expected to fall back to the BoE's 2 per cent target for some time.
Economists point to above inflation increases to public sector pay, as well as the living wage and NI hikes, as driving a decoupling of UK CPI from peers in the G7 and ending a trend of parity that had persisted in the run-up to last year's election.
At the same time, higher labour costs have already started to hit the jobs market with unemployment inching higher from historic lows and the vacancy rate shrinking.
Chief economist at the Institute of Directors Anna Leach said Labour's tax increases on business 'have already undermined' its industrial strategy's ambition 'to make the UK the best country to invest anywhere in the world'.
She added: 'The reality is that the government has been much more radical in taxing business than it has been in removing blockers to growth.
'We need to see faster progress and greater ambition on de-regulation – particularly planning reform – and a reconsideration of the tax landscape for business if we're to change the UK's economic fortunes.'
Economic momentum also faces battered consumer confidence, which has seen Britons prefer to crowd cash into savings rather than spend.
The Office for Budget Responsibility slashed its full-year forecasts for GDP growth from 2 to 1 per cent for 2025 in March, with the economy expected to expand by around 1.5 per cent over the next five years.
But the BoE is reticent to come to the Government's rescue to avert further economic deterioration with bumper interest rate cuts. The central bank has consistently signalled a slow-and-steady approach to keep inflation under control.
The BoE is still expected to cut rates twice more this year, taking base rate from 4.25 to 3.75 per cent. While the US Federal Reserve is also cutting slowly, the European Central Bank has already reduced its key policy rate to 2 per cent.
Franklin Templeton's Browne said: 'If you have an imbalance - if monetary policy and fiscal policy are out of sync - then that's going to remain the case for a long time.'
Bond market demands: Cuts or tax hikes?
A slow-and-steady approach to interest rate cuts amid higher inflation is likely to keep long-term government borrowing rates at already painful levels, even as the UK issues even more gilts.
'Gilt market spreads signal concern over a deterioration in both the current budget balance and total government borrowing aggregates,' said Panmure Liberum's French.
The passage of the Government's welfare reforms was intended to save as much as £5billion, but their dilution still leaves the Chancellor facing a multi-billion pound hole to fill if she is to maintain her fiscal rules.
Reeves had hoped that improved economic growth would free her of the need for further painful spending cuts, or for her to break the Government's pledge not to hike taxes on individuals.
In absence of any material growth, however, tough choices loom this autumn.
Browne said: 'Her options are now [are]; one, tax more, no doubt focused on companies and wealth. Two, not care by pretending it's not a problem and lose all credibility, [or] three, find cuts elsewhere.
'Option one pushes the economy towards the doom loop of tax and spend. Option two scares the bond market as did Truss during her 44 day Premiership, [and] option three we know won't happen.
Darius McDermott, managing director at Chelsea Financial Services, added: 'While Reeves' policies may be flawed, the real concern for investors is that a potential replacement could push the party further to the left at a time when markets are desperate for signs of credible fiscal leadership.
'Without a clear pivot towards tough decisions, the risk is this discomfort could spiral into a broader crisis of confidence in UK debt.'
The large gap between yields on longer-term UK government debt compared to G7 peers demonstrates bond investors' inflation concerns