The Future of the UK Economy Under Labour's Policy Framework

The UK heads to the polls on 4 July, with predictions pointing to a sweeping Labour victory. This would mark the first Conservative-to-Labour transition in 27 years. Major political shifts in the UK have historically been followed by profound economic changes, and this occasion might be no different.

Rachel Reeves, who will become Chancellor of the Exchequer in a Labour government, has outlined a comprehensive framework for Labour’s economic policy, focusing on addressing Britain’s supply-side crisis and drawing parallels to current US strategic economic policies. Labour aims to play a long game, being tactical with borrowing and tax policies, while looking for policy levers to facilitate strategic, long-term investments to boost productivity, trade and energy security.

If Labour can make progress toward these goals, we believe investors should anticipate the British pound to reverse its weakening trend, and the Bank of England (BoE) policy rate may revisit pre-2008 ranges.

Reeves’ supply-side blueprint for Labour

In March, Reeves gave an important speech outlining a broad set of guiding principles for Labour’s economic policy agenda. Reeves’ argument is based on Labour’s views that Britain is facing a supply-side crisis caused by insufficient investment across almost every part of the public sphere. She also highlights policy instability, which she claims has led to business under-investment.

Reeves envisions a rise in global strategic resource competition, particularly in energy, and views the UK's current global trading frameworks as unfavorable. Drawing clear parallels to US strategic economic policy, especially regarding fostering investment in domestic production in key sectors, she argues that these issues have hindered productivity growth and are a key reason why real incomes have not grown as expected. This is a critical link to the foundational principles of the Labour party.

Labour's vision: balancing caution and ambition

Labour has been intentional in suggesting that it will be cautious with borrowing and changes in tax policy. At first glance, this seems difficult to reconcile with implementing a wide range of supply-side changes. The party, however, is buying itself time by arguing that its agenda spans the entire five-year term and sometimes, perhaps presumptuously, discussing plans that will bear fruit over ten years. This political strategy may prove economically savvy, in our view. The economy is starting to rebound, and inflation is in a more stable and arguably healthier place. More importantly, there are likely some policies to be pursued that have a good multiplier effect and would make future actions easier to implement. For example, upfront healthcare investment may address significant labor force participation problems, which in turn can generate broad-based benefits.

Sterling's decline and the path to recovery

The British pound has experienced a prolonged decline against the dollar, driven by many of the factors highlighted in Reeves' analysis. Sterling depreciated meaningfully following the great financial crisis (GFC) and again after Brexit. It further weakened as the post-Brexit regime shifted away from a customs union toward a setup less favorable to the UK.

The exchange rate may partially reflect poor expectations for the UK's economic prospects. In our view, this creates a low bar and suggests there may be potential for improvement if Reeves' framework for enhancing growth, trade, incomes and energy security proves even modestly successful. The burden of proof lies with the next government, but it may benefit from favorable winds at its back. If polls are accurate, Labour will wield considerable political power.

BoE bank rate may settle in pre-GFC ranges

Since 2008, BoE policy has been shaped by assumptions of declining economic expectations, influenced by a prolonged absence of productivity gains. Under this framework, the bank rate never exceeded 75 basis points (bps) until the late-2021 rate hike cycle began. The BoE also pursued a long-running quantitative easing policy, reflecting its belief at the time that the bank rate could not drop below 50 bps. Now that rates have reached 5.25%, the BoE is holding at that level while reducing its balance sheet and suggesting that it is close to cutting rates. The fiscal agenda stands to benefit from easing monetary policy and the growth upturn that is now underway.

In pursuing its inflation target, the BoE must focus on the future rather than the recent past. It may see potential productivity gains from supply-side reforms that could alleviate concerns about recently observed wage growth leading to problematic inflation dynamics. At first glance, this might seem to suggest a larger rate-cutting cycle. But if the BoE also believes that potential growth is higher, we think the bank rate might comfortably remain in the 4–6% range, as it was before the 2008 crash. In our view, a bank rate within this range, with yields notably above the inflation target, would be very positive for gilts and would continue to support policy implementation.

First comes power, then comes policy

We acknowledge the uncertainty surrounding future political events. Our investment approach is not centered on elections but rather on mapping out probable actions based on our understanding of economic thinking among policymakers. We see the Labour party’s proposals having significant economic ramifications, though change will take time. We remain focused on integrating this analysis with our assessment of the credit cycle and monetary conditions to guide our investment decisions.

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