Gilt market faces higher public spending under next UK government

The UK faces increase in public spending under the next government, regardless whether it is led by Labour or the Conservatives, but gilts may benefit initially from a flight to quality.

Labour has already committed to higher spending in its campaign manifesto, but Howard Cunningham, fixed income portfolio manager at Newton Investment Management, says the Conservatives may have to increase commitments if they want to form a coalition.

This would put some upward pressure on gilt yields and gilt issuance, Cunningham says, adding: “A less stable coalition government would lead investors to demand a higher risk premium, so gilt curves should steepen.”

Gilt yields would also head higher under Labour, Cunningham says “as higher public spending would engender higher gilt issuance, and faster increases in minimum, living, and public sector wages would suggest higher inflation”.

“Index-linked gilts could be expected to outperform conventional gilts, but could still produce losses for investors.”

However, Brexit remains the main determinant of longer term exchange rates and gilt yields, says Cunningham.

“In the event of a hung parliament, the UK’s negotiating stance is likely to be less clear cut, and more time will be needed domestically to agree on a position, leaving even less time to do a deal with the EU.”

Cunningham says while EU institutions may see benefit in a more divided UK, national governments and central bankers on both sides of the Channel may be more fearful of the potential impact on economies and markets stemming from this greater uncertainty.

Lessons from 2010

The UK faced a hung parliament seven years ago when the 6 May election delivered no majority to any one party.

AJ Bell investment director Russ Mould says the gilt market “wobbled a little” in the six days it took for the Conservatives and Liberal Democrats to form a coalition government.

The yield on the benchmark 10-year Gilt rose to 3.78 per cent from 3.74 per cent, but over the following year fell to 3.4 per cent.

However, Mould says: ““This was as much due to the fundamental backdrop: a recovery from the financial crisis and ultra-loose monetary policy from central banks the world over, in the form of falling (or record-low) interest rates and QE. UK politics, next to that lot, meant relatively little.”