We believe that the reaction of the government bond market to the elections may reflect a long-standing issue, namely the growing perception that Britain is living beyond its means. The ratio of public debt to gross domestic product (GDP) now stands at nearly 94%, roughly the same level recorded since the start of the pandemic and the government response at the time, which was incredibly costly (from £310 billion to £410 billion1, according to official estimates). Similarly, the UK budget deficit is now nearly 5% of GDP, below the 10% peak recorded after 2008 and the 15% reached during the pandemic, but still higher than the 2000-2007 period, when it rarely exceeded 3%*. Repeated shocks have forced successive governments to high spending, but the issue does not end there. Persistent unemployment and long-term illnesses in some sectors of the population have led to unsustainable social spending. According to the Department for Work and Pensions, this alone is expected to cost taxpayers £337 billion2 in 2025-26.
Foreign investor willingness is waning.
The UK government bond market (gilts) represents a crucial source of financing for the UK, and the reliability of the British government, perceived (until recently) as solid, has meant that international bondholders were generally willing to buy UK public debt in exchange for the yields offered. However, as Britain has had to contend with a growing debt burden, the role of these financiers – who now hold nearly a third3 of the UK gilts outstanding – has become increasingly important. Then Bank of England Governor Mark Carney noted in 2016 the “kindness of strangers” willing to buy British gilts when they were beginning to reflect less their literally “top-tier” status. The short-lived Truss government of 2022 – during which drastic unfunded tax cuts were proposed – saw patience with the UK run out, and 10-year government bond yields approached 4.5%*, as investors applied a risk premium to this asset class.
The bond market “vigilantes”: markets extremely sensitive to fiscal policy
It is likely that any successor to Prime Minister Sir Keir Starmer will be more willing to adopt a more ambitious program, which could further increase public spending. This in turn suggests that the government bond market could continue to act as a volatile barometer of Britain’s fiscal health, potentially compromising its role as a stable source of income and diversification until a more disciplined approach is adopted, either voluntarily by the government or at the insistence of the bond market demanding higher yields before buying securities.
Double trouble: rising business costs and domestic political uncertainty weigh on confidence
As for the UK equity market and currency, the reaction to the elections was equally significant. The FTSE 100 index fell by 1.6% on election day and by 0.4% the following day, with only a partial recovery in subsequent sessions. Already grappling with high business costs, the stock market “got spooked” at the prospect of a leadership change, despite Prime Minister Starmer’s relative unpopularity. The pound also showed volatility, slipping on election day before recovering and then sliding again. A stable currency is particularly important for the UK stock market, with FTSE Russell noting in 2024 that over 80% of FTSE 100 revenues now come from abroad4. This does not necessarily mean that a genuine currency weakening is a benefit for the companies comprising the index if it actually reflects political uncertainty over the future national tax regime. The immediate reaction to the elections and their aftermath seems to illustrate this point. Now, after a series of strong performances over the past two years, in a context of global rotation towards low-cost markets and commodity strength, the FTSE 100 may face a new source of domestic uncertainty.
Investable, but not irresistible: pragmatic reasons to maintain exposure to the UK
The above may not seem particularly encouraging for investors, but this does not necessarily mean that the UK should be carefully avoided. It may be prudent to maintain a modest exposure to UK government bonds within portfolios, as part of a broader and diversified government bond allocation, to provide protection against extreme market events. After all, it is generally not considered likely that the British government could default outright on its debts, even in extreme situations. As for the equity market, the FTSE 100 index remains somewhat of a value proposition, with an expected price/earnings ratio just above 13 times, compared to the more expensive 22 times of the S&P 500* as of May 14.
That said, a significant overweight in UK equities and bonds may be difficult to justify while British politics grapples with the simple fact that there is not enough to go around in the current low-growth economy. For UK-based investors – as opposed to investors investing in the UK – there may still be some consolation in all this.
As returns from successful foreign investments, such as those in the US technology sector, are converted into pounds, the volume of such pounds will increase if the currency adjusts downward to reflect Britain’s precarious situation. This could leave globally oriented but UK-based investors in a somewhat conflicted position, where they might potentially benefit from the ongoing chaos; however, the more pragmatic among them will likely simply be grateful for the hedge.
