Sir Robert Walpole was the UK’s first prime minister, a post created in 1721 – technically named the first lord of the Treasury – to sort out the corruption and destruction of the UK’s financial system caused by the 1720 South Sea bubble.
As a result of his success, he served for over 20 years and oversaw the start of the industrial revolution.
When sir Keir Starmer was elected, winning a parliamentary landslide of 412 seats – though on a historically modest vote share of just 33.7%, one of the lowest winning tallies in modern British electoral history – it was hoped he too would reform government and deliver both economically and socially, after the vicissitudes of the May, Johnson, Truss and Sunak years.
After two years and fifty bills, the mood of the UK has turned decisively against him and his government. Economically, there has been little or no recovery. Socially, there has been no perceived improvement in the services or output of government, whether it is potholes in the roads or the NHS.
Instead of cleaning up government, once again we have a prime minister mired in a scandal of his own making. Consequently, the Labour party has reached its lowest poll ratings in history, plummeting below even the lows experienced during Michael Foot's leadership in 1983.
On 7 May, in the local elections, the Labour party are forecast to poll less than 20% of the vote – as are the Conservatives, and may find itself without a meaningful political base across the country. In particular in London, where losses in its crucial heartland could be crushing.
This would lead to calculations that, if a general election were held tomorrow, 90% of its current MPs would lose their seats, either to Reform or to the Greens. The Parliamentary Labour Party (PLP), already difficult to govern, would become ungovernable.
At this point, Labour will be forced to change leader. This is a slow process, requiring firstly 20% of MPS to call for a contest; then, after hustings, the two leading candidates face a vote from the whole party membership.
In total this will take around 12 weeks from start to finish. To complicate this race further, the current leader is automatically allowed to stand in the final party- wide ballot.
What does this mean for investors?
Before examining each scenario for the implications for investors, it's worth reminding ourselves that the key variables are gilt yields, sterling, domestic equity valuations and the path of Bank of England base rates. Each of the two scenarios described below carries a distinct risk profile across all four.
With net interest payments on UK government debt running at approximately 10-12% of total government revenues – among the highest debt-servicing burdens in Europe – very little fiscal headroom exists regardless of who leads the country. Any new leader – likely to fall into one of two categories: a radical alternative or a continuity candidate – is likely to be severely constrained by this.
In the first case of the radical leader, the new prime minister must be prepared to drive through significant changes in the distribution of welfare at the expense of wealth.
That may mean attempting to break the fiscal rules currently in place in order to accelerate social reform – no doubt incurring the wrath of the markets, in the way the short-lived Truss administration did in autumn 2022.
In this circumstance, the impact of fiscal policy would likely push gilt yields higher, worsening the interest burden the UK already suffers, the heaviest in Europe. That would bring the Bank of England into view: if policy were deemed inflationary, rate increases would follow.
The Bank is already under pressure as a result of the Iran conflict, as the ongoing military engagement in the Middle East has pushed energy costs materially higher and may push up other costs as well.
The Monetary Policy Committee’s (MPC’s) report on 30 April should leave no one in any doubt that the majority of members are ready to act swiftly if inflation threatens to get out of hand. A rise in taxes and an increase in interest rates would push an already weak economy into recession. It may also provoke further weakness in sterling, leading to further inflation.
The distributional consequences of rising rates matter enormously here. Due to the heavy savings in cash by the older generations, the UK benefits arithmetically from rising rates, which theoretically puts more cash in than it takes out. But its distribution is skewed by age, meaning the hit is taken by younger, family-building voters, while the gain is felt by older, low-spending voters.
Labour’s strength lies with the aspirational 30-39 year olds, where some 65% voted Labour, Liberal Democrat or Green. Rate rises will not help them and a radical Labour leader would find themselves in the uncomfortable position of delivering precisely the monetary tightening that harms their own coalition most.
For investors, a radical leadership outcome is the higher-volatility scenario. Expect gilt yields to reprice sharply upwards, sterling to come under pressure and the risk premium on UK assets to widen, alongside the inevitable loss of business and consumer confidence.
In the second case, a continuity candidate finds their options inevitably constrained by the markets and by debt and works within this narrow corridor. This is, in essence, old wine in new bottles. If they fail to deliver rising living standards, it will merely prolong the this government without improving its prospects – much like the last Conservative administration.
The two radical parties, Reform and the Greens, gather further support, benefiting from slow decline and exploiting disillusionment with the mainstream. This is where the two-party system fractures, leaving the next general election impossible to call – except that Labour will perform poorly.
In this scenario, markets would demand an ever-increasing premium for UK assets: debt and equities alike. Whilst there would be less chance of a market shock, the lack of a coherent programme becomes the persistent drag. The risk of a hung parliament after the next election adds further uncertainty.
In this scenario, markets would demand an ever-increasing premium for UK assets: debt and equities alike. The lack of clear governing majority of a coherent programme, rather than any single policy shock, becomes the persistent drag.
For investors, the continuity scenario brings less volatility in the short term but remains structurally corrosive. UK domestic equities remain cheap on almost any valuation metric but the discount will persist and may widen until a credible fiscal consolidation path becomes visible. That path is unlikely to emerge before the politics are sorted.
For the next three years, an early election is very unlikely, so the prospect of a formal end to one hundred years of UK political stability can be deferred but not ignored.
Some of that risk is undoubtedly priced into gilts as this is not new news, although visibility of the end game is becoming clearer.
The political and thus economic alternative is a sharp cut in government spending and fiscal austerity, perhaps offset by interest rate cuts. But this will not be available until after the next election and only if a right-of-centre coalition forms.
For now, investors are being asked to 'keep calm and carry on' or otherwise known as the grin and bear it stage!
Michael Browne, global investment strategist at Franklin Templeton Institute. The views expressed above should not be taken as investment advice.