Are politics important for the pound once more?

Could PM Sunak offer significant fiscal giveaways to try to win the election?

But then came Liz Truss last September as the blink-and-you-missed-it Prime Minister and suddenly the politics of unfunded fiscal giveaways upended the pound, trounced gilts and nearly ended the life of some pension providers. So, is politics important again for the pound? This could be an interesting question given the fact that the pound has been the best performing G10 currency this year and that general election looms next year.

This week sees three Conservative-held by-elections in the UK, and the government should lose them all. It seems likely to lose them by quite some distance to both Labour and Liberal Democrats in what will be stinging rebuke to PM Sunak’s short time in office. Of course, it is common that incumbent government’s struggle in by-elections and this time is no different as the economy endures a stagflationary malaise and nationally the Conservatives are polling some 20 percentage points behind Labour.

According to the Standard Bank, sterling and gilts are not going to be damaged materially if these seats are lost. But hefty losses this Thursday raise three key questions that could, ultimately, have a bearing on UK asset prices.

The first is whether the Conservative Party will try to cut and run again by ousting Sunak as leader and PM.

The second is whether the dire polling position will tempt Sunak (or his replacement) into another go at unfunded fiscal largesse to improve public support.

The third is whether bulls of the pound and/or gilts will grow wary as the (very likely) prospect of a Labour government looms into view next year. Perhaps fortunately, we are not particularly worried about any of these possibilities. Ousting Sunak might appear tempting at the end of the year if, as seems likely, the PM falls short of meeting the five pledges he made at the start of the year, including one to halve inflation. But while failure to achieve these pledges could give the Conservatives an excuse to try to oust Sunak, the Party does not seem to have an “oven ready” (to quote former PM Boris Johnson) replacement that can win the election.

Indeed, a number of those touted as potential leaders in the past, such as former deputy PM Raab and current Defence Secretary Wallace have already said that they will not be standing as MPs at the next election. This, in itself tells you a good deal about how many Conservative MPs are very negative about the Party’s chances at the next election.

Could PM Sunak – or a new Conservative leader – offer significant fiscal giveaways to try to win the election? In Standard Bank’s view, this too would seem unlikely given that Sunak’s whole rasion d’etre seems to be to rescue the country (and sterling and gilts) from the mess created by former PM Truss’s budgetary mayhem.

However, some sort of fiscal action still seems likely and even if the finances are so tight that nothing can be delivered before the election, Sunak looks sure to make some big fiscal promises should the Conservatives win the election, if only to try to put Labour in an uncomfortable position. But any such fiscal easing, or promised tax cuts, will not turn the Conservative’s fortunes.

An election loss next year seems pretty assured and that could turn the markets attention to Labour’s policies. Last time there was an election in 2019 Labour went in with an extremely radical left-of-centre programme. But it had virtually no chance of winning (the bookmakers put its odds at around 20 or 25-1). Hence the market did not seem to take much notice. This time around its chances of winning are much higher (odds-on according to bookmakers) but its programme is far less radical.

Indeed, some might even argue that it is more conducive to gilt and sterling strength given Labour’s more friendly posture towards Europe, even though it still rules out re-joining the EU. The bottom line is that we don’t see a big danger for UK assets from a Labour victory, from Conservative pre-election fiscal irresponsibility, nor from a swift ousting of PM Sunak.