Market Views: Time to brace for Starmer ousting?

Elections on 7 May could be the tipping point for the UK’s embattled prime minister, Keir Starmer, potentially heralding a leftward shift in the government that could have important consequences for investors.

Starmer has faced repeated calls to resign in the face of multiple strains on his leadership. The latest problem relates to whether he misled parliament over Mandelson. Labour MPs mainly backed the PM in a vote last night. But elections pose a graver threat to his premiership. 

Without getting too much into the weeds of polling data, it’s clear that Labour is heading for a drubbing in Wales, Scotland and English local elections. Significant losses could spark internal revolt and already the bond market may be reflecting the political uncertainty and ensuant fiscal risks, in addition to the immediate inflation concerns stemming from the Iran war.

As noted in February, when Scottish Labour leader Anas Sarwar called on Starmer to resign, gilt markets are very sensitive to any prospect of Starmer being replaced, which in all likelihood would also see chancellor Rachel Reeves fall: 

“The market is worried about a) political uncertainty and b) that any replacement of the Starmer-Reeves regime would be from the left, implying more spending and potentially unwinding all the fiscal repairs carried out at the last Budget. Incidentally, it’s this fear of an attack by bond vigilantes that just might save the PM, though it’s looking increasingly less likely he will survive as Labour leader by the May elections.

“In the Budget last November, the chancellor’s move to raise taxes and fiscal headroom eased concerns about debt sustainability and immediate fiscal risks. Reeves is seen as the most ‘market-friendly’ possible candidate as Chancellor within the government. 

“Following a rough summer ahead of the Budget and a global bond selloff, 10yr gilt yields had declined from around 4.8% at the highs last September to around 4.4% last month. No surprise then that this turmoil in Downing St has seen 10yr gilt yields inch up about 8bps today to 4.59%, touching 4.6% at the highs.”

Now gilt yields have risen further with the 10yr above 5% to test 2008 levels. This is partly an inflation risk premium but also reflects fears about the politics and a potential shift to the left, as well as structural fears about the UK’s high debt levels. Meanwhile various economic think tanks are warning of hit to UK economy from the war leading to smaller tax receipts and evaporating fiscal headroom, which risks embedding a higher fiscal risk premium in gilt yields.

All of Starmer’s would-be successors are further to the Left of the Labour Party. Front-runners such as Andy Burnham talked about how the UK should not be “in hock” to bond markets; the sort of language that markets hate. Another leading contender is Angela Rayner, whom it is reported could be brought back into the government to fend off insurgency; but ultimately the elections could prove the final straw. Bringing back Rayner appears to be a last-ditch attempt to rescue his premiership.

Bond markets would prefer Starmer and his chancellor Reeves to remain in place. There is a risk of significant volatility in the gilt market – a Truss-like episode – if they are defenestrated. Markets have consistently shown support for Reeves’ s adherence to her fiscal rules - yields jumped +22bps in a single day last summer when the market was worried about her leaving the government.

A leftwards lurch would raise hackles among bond vigilantes at a time when the fiscal risks are already rising due to the rise in inflation from soaring energy prices and weaker growth outlook for the economy. In the event of a new leadership ticket there is a risk of additional government spending on cost-of-living measures such support for rising energy bills, increased minimum wage, benefit uprating and a rental freeze, among a range of potential help mechanisms. It would be a toxic combination for gilts – higher spending, lower growth and inflation becoming embedded.

The bond market may eventually enforce fiscal discipline on any new leadership, however this would not come without first a lurch higher in yields and potential dislocations. Ultimately the outlook for inflation and gilt yields will be dependent on the outcome of the situation in the Middle East and the persistence of the energy shock, as well as the reaction function of the Bank of England to higher prices.

Whilst gilt yields would rise sterling would fall although some positive carry from higher yields would help offset the fundamental weakness of the economic outlook.

There are also considerations for the equity market. 

Banks – could face a tax grab as they only narrowly avoided one last year and profits have been soaring. Lloyds today reported a 33% rise in pre-tax profits and 17% returns on tangible equity (Rote) but the sustainability of these elevated returns would be in question if the government were to look at higher bank taxes. Angela Rayner last year called for the bank surcharge to rise to 5% a year from the current 3% rate. 

Oil & gas – also an area where the government could seek to raise more cash from windfall taxes. Reeves on Tuesday said BP’s bumper profits must be “taxed appropriately”. BP reported a surge in quarterly profits yesterday. In response Energy Secretary Ed Miliband, who is being talked about as a potential successor to Reeves as Chancellor, said "it would be completely wrong for a Government to stand by and allow companies to make excess profits from a war".

Property – talk of a rent freeze – which some reports suggest Reeves supports - already hit shares in Grainger, Britain’s largest listed residential landlord. Housing secretary Steve Reed has ruled it out for now but I think this is exactly the kind of policy that would appeal to many of Labour’s would-be leaders.