New UK prime minister, same bond market

Rob Armstrong and Ian Smith discuss the implications of Andy Burnham becoming the next UK Prime Minister. Despite being caricatured by investors as market-negative and left-leaning, gilt yields have actually fallen and sterling remained stable when his victory became certain, indicating a surprisingly calm market reaction.

Smith explains several reasons for this calm response: global inflation threats are diminishing as the Iran conflict abates, and Burnham has strategically repositioned himself as a centrist focused on fiscal discipline and welfare spending controls. He has walked back earlier controversial comments about not wanting to be "in hock to bond markets" and about taking defense spending outside fiscal rules.

The conversation explores why the UK is particularly sensitive to global economic shocks. The UK entered the Iran conflict with inflation already running at 3% (higher than the eurozone), making it more vulnerable to energy price spikes. Additionally, the UK's high gas boiler penetration increases energy sensitivity. The UK also started with elevated borrowing costs in the G7, and Brexit has created sticky inflation and constrained fiscal space. The pound can be targeted by international investors during fiscal concerns, unlike the US dollar's reserve currency status.

Smith identifies a negative feedback loop: high borrowing costs constrain centrist politicians' spending priorities, limiting their popularity and fueling populist politics on both sides. This contrasts with the US, which benefits from reserve currency status that guarantees bond purchases.

Regarding the Bank of England, traders expect only one quarter-point rate increase by February 2024, down from earlier expectations of multiple increases. This could provide gilt market support. The real question for markets is whether Burnham will stick to fiscal rules or test the limits of bond market tolerance through increased borrowing.

Armstrong raises the concern that the UK may face structural ungovernable dynamics similar to Italy's debt crisis period, asking whether successive unpopular leaders reflect permanent structural problems. Smith resists full pessimism, arguing that while certain dynamics persist regardless of leadership, bad feedback loops between fragile bond markets and politics remain changeable. He emphasizes that growth is the ultimate solution—the "deodorant" that solves multiple problems simultaneously, citing Bill Clinton's 1990s experience as a parallel.