How's that UK Bull Case Looking?

Rising gilt yields, a weaker pound, and the outlook for the UK economy

Photo by Greg Lauver on Unsplash

When I started this Substack in May I wrote a post making a bull case for the UK, noting how unnatural it is for most Brits to do this, while starting with what I felt was a rallying cry of “the reality is that the UK was, and remains, among a small group of rich nations in which you’d be more than happy to be born”. The post has since been viewed 88 times, so I like to think I really moved the needle there.

But I bring it up because there’s precious little positive sentiment on the UK right now, and it’s worth reflecting on how much of this is justified. Headlines this week have exclaimed that 30-year gilt yields are at their highest since 2008, that GDP growth is barely positive, and that inflation remains rampant.

The government is boxed into a corner, borrowing costs are rising, and stagflation – that ugly relic of the 1970s describing a period of high inflation and unemployment alongside low growth – is lurking on the horizon. The UK is in the eye of the global bond market storm. The Chancellor must cancel her trip to China to get through this gilt market catastrophe!

It's not a pretty picture, but the media can be easily prone to hyperbole, especially since the Liz Truss, lettuce, LDI, market meltdown of September 2022. So, let’s try and move away from that, and look at why was I positive in May and what’s changed since.

The positive case for UK growth

My case back then rested on four pillars: first, that falling interest rates would provide relief to consumers, with the Bank of England tolerating a moderate level of inflation, enabling real wages to rise; second, that corporate and consumer balance sheets were strong, and a more stable political and economic backdrop would unleash spending and investment; third, that the government could manage its fiscal challenges through some sensible tax raising measures and a bit more borrowing; and fourth, that planning reforms, closer alignment with the EU, and ultimately higher public and private investment, could reap long-term growth benefits.

Looking back, I don’t think it was a bad argument, but the world is messy, and the best-laid plans get blown off course. There were two big things I missed: one outside the UK’s control, the other within it.

Out of the UK’s control: The Trump factor

The first was the election of Donald Trump and its impact on global yields. If you look at a chart of UK and US government borrowing costs, they tend to move in lockstep. The last 1, 3, 6 or 12 months are no different to the pattern of the last 20 years. (For more on the relationship between yields and just all things bonds, this is a great article).

What’s happened since September 2024 to move global yields higher is a change in expectations about the path of interest rates in the US, which influences the path of interest rates elsewhere. Markets expect fewer cuts from the Federal Reserve today than they did last summer because they think inflation will stay higher. Why? Because Trump started going all Trumptastic on raising tariffs and deporting millions of workers, the consequences of which are likely higher prices and wages. Couple that with strong underlying economic data and you have a reset in US interest rate expectations that the UK is merely a supplicant to.

Gilt yields though aren’t the whole story of this week’s market moves. The pound has also fallen and it’s this combination of higher yields and a weaker pound that implies more UK-specific concerns bubbling around (because typically higher gilt yields would attract buyers into UK assets, leading the exchange rate to rise).

According to the FX team at Deutsche Bank (via FT Alphaville), the UK’s major problem is its external deficit i.e. its reliance on foreign investors to purchase gilts. This makes it more vulnerable to US yield rises and the only way out is for the currency to weaken (emphasis mine):

From the perspective of external flows, the UK is one of the most vulnerable in the G10: it has a big current account deficit and capital flow deficit (chart 2). By extension, the marginal price setter of the value of gilts is not domestic policy but global yields (ie US Treasuries). When US Treasuries sell off, gilts should sell off more than other bond markets. Given this predicament, how does the UK get out of a vicious circle of higher yields, lesser fiscal space and lower growth. In a world of floating exchange rates the answer is simple: a weaker currency. A weaker pound does three things. First, it helps improve the country’s negative net international investment position by a mechanical revaluation of UK-owned foreign assets. Two, it cheapens up UK assets (= gilts) so eventually they become attractive to buy again for a foreigner. Third, it helps the current account deficit adjust, reducing the reliance on foreign funding.

The sell-off in the pound is the flipside of the rise in gilt yields, and the rise in gilts yields is driven by what’s happening in the US. To blame all of this on Labour’s economic management (as some commentators seem want to do) is ludicrous.

Self-inflicted wound: Falling consumer and business confidence

But there’s no denying that the UK is more vulnerable to international currents because of its underlying economic position, and this position looks weaker than in May.

Economic data over the last few months has been consistently poor: GDP growth in Q3 was zero; consumer confidence cratered in September and has barely recovered since; manufacturing has contracted for three months in a row; and even the buoyant services sector has begun to slowdown.

There has been no unleashing of consumer or business investment. Instead, there is growing evidence that the decisions made in the October budget, particularly the rise in National Insurance (NI) contributions for employers – a tax paid by business on workers – are partly to blame.

Full disclosure here, I got the impact of this wrong.

Not that I thought piling an unexpected tax rise on business was the best option, but after ruling out raising VAT, income tax, or employee NI, there weren’t many options left. And since the prior Conservative government had made two cuts to employee NI at the end of the last parliament that simply weren’t affordable (which they well knew), the increases announced in October were merely putting the tax burden back to where it was two years ago.

Perhaps this would have been fine in a less fragile, more certain world, but that’s not where we are today. The rise in NI came as a big shock to companies – looking at announcements since then has made that clear – and will be passed through in the form of lower profits or higher prices. In retrospect it was both bad economics and bad politics.

Getting out of the hole

External events and some poor decisions have knocked the UK off course, but this doesn’t mean it has no room to manoeuvre. The economy isn’t doomed to a downward spiral.

In terms of the immediate problems in the bond market, the UK’s fate remains largely tied to the US. At the margin, the Bank of England could cut interest rates more than currently expected, running the economy “a little hot” while accepting a higher level of inflation than its 2% target.

But this won’t be cost free – any major divergence in rates from the Federal Reserve will place further pressure on the pound. To get out of the rising yields, weaker pound scenario, evidence of underlying economic improvement, or a change in the fiscal position, may be required.

Of those two, the fiscal position is most under the government’s control, they just need to show a lot more courage and creativity than they’ve done to date.

A more nimble politician than either Reeves or Starmer would have avoided boxing themselves into a corner over tax rises, and either reversed the Conservative tax cuts to NI, or expanded the base of income tax. That may be where we end up.

A more courageous politician would have initiated a fundamental reset of tax and spend, levelling up capital gains and income taxes, removing tax breaks on the self-employed, making pensioners pay national insurance, raising property taxes relative to income, removing the triple lock for pensioners, looking at the welfare bill. Not pretty options, not popular options, but options no less – and ones that don’t require massive cuts to health, education or defence.

If I’m honest though, I have a lot less confidence that the government can and will make these changes than I did in May. And I have a growing worry that after being criticised for missing inflation on the way up, the Bank of England will be too cautious in cutting interest rates on the way down. I’m not throwing in the towel completely on an improving outlook for the UK, but I think it requires a greater leap of faith, and will take longer, than I did before.

Let’s be clear though, we’re not talking about economic collapse, we’re talking about continued low growth. There is a price for everything and there will continue to be opportunities to invest in good UK businesses at attractive prices, or risk-free gilts at the highest yields in decades. I plan to keep looking for those!