JP’s Journal: Sunak’s election gamble

The surprise announcement of a general election drowned out other developments last week. It is a gamble for a governing party to test its popularity when opinion polls suggest a 20-point deficit.

There are two possible explanations: the Prime Minister thinks he can turn things around in six weeks, helped by better economic news, or that the outlook will be worse in the autumn and it is a damage limitation exercise.

Markets are generally a good discounting machine and the lack of movement in equities and bonds indicate that investors are convinced of the outcome. Bringing forward a Labour government by a few months really does not change the picture.

The election announcement came on a day when UK April inflation data showed a sharp fall. This can be portrayed as good news but, in reality, the headline rate will have come as a disappointment to the Prime Minister. Yes, the headline Consumer Price Index (CPI) inflation measure declined from 3.2% to 2.3% but this fall was less than expected. Overall, there was good news on the energy and food front and most of the main categories contributed negatively or neutrally but there was an upside in contributions from restaurants and hotels. Indeed, services inflation barely moved, just below 6% but a long way from the estimate of 5.4%. Unfortunately, stickiness in services inflation seems widespread. One factor may be the rise in the minimum wage to £11.44 per hour; it appears that businesses have been able to pass on these higher anticipated costs to the consumer.

There is no mistaking that the CPI figure was a blow. In my view, this data, coupled with the general election announcement, rules out a June Base Rate cut. This has been reflected in market pricing with the probability of a reduction next month falling from over 50% to around 10%. Leaving aside the Bank of England’s (BoE) desire to remain politically neutral, domestically driven inflation is just too high to take a risk and would send the wrong message to investors about the seriousness of the BoE’s inflation credentials. Waiting a while for confirmation that services inflation is moderating seems a sensible choice. The May CPI data, when released, could see the headline rate below 2% but this will not be sufficient on its own. From an economic viewpoint, the focus has shifted from the headline rate to services inflation, as a proxy for domestic price pressures, and this is proving to be much more difficult to get down.

One reason put forward for an early general election was the deteriorating outlook for public debt. Despite higher growth and taxes, UK public borrowing was surprisingly high in April and the 2023-24 estimated deficit was increased to 4.5% of GDP. In April, debt interest payments jumped from £2.5bn to £8.6bn due to the inflation rise seen in February. With up to £12bn payments for the contaminated blood scandal due to victims, the scope for further tax cuts in the autumn was diminishing, although the magic of five-year rolling targets may have given the Chancellor wriggle room. We will never know.

On the credit front there was an interesting story about the first losses suffered on AAA rated bonds since the financial crisis. According to Bloomberg, buyers of the AAA portion of a $308m note backed by the mortgage on a midtown Manhattan property got back less than 75% of their original investment when the loan was sold at a steep discount. All lower rated creditors were wiped out. This was a single mortgage, tied to an older office building, both of which added to the risk profile. However, it is a reminder of the distress in US commercial real estate with cities such as Chicago and Denver showing particular weakness. The effects of higher interest rates are creeping through US commercial property values. So far, the consumer has remained relatively immune, buoyed by strong employment condition and positive wealth effects from stock market and residential housing.

Following stronger-than-expected US Purchasing Manager Index figures, government bond markets trended lower weaker, with UK gilt yields rising 14 basis points at the ten-year mark. Credit held in, with higher yields reflecting movement in underlying government bonds. There has been no specific impact on sterling credit sectors from the election announcement but it is likely that there will be further attention on the Labour party’s policies towards utilities.

The election call is a gamble and the Prime Minster has a weak hand to play. The following weeks will show whether he can close the gap, surprising pundits and markets. It seems a long shot.

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