by Mr. Steve Barrow, Head of Standard Bank G10 Strategy 12/01/2024, 11:08

What will drive the pound in 2024?

There has been some talk recently that political parties vying to win this year’s UK election could propose the sort of fiscal largesse that rekindles memories of the September 2022 gilt market crisis, which also weighed heavily on the pound. But we don’t buy it.

In some ways that whole crisis could turn out to be beneficial in the future, at least for the pound.

There is little doubt that the Conservative government is going all out to find a way to dole out tax cuts ahead of an election that’s likely in the Autumn. The start of this year sees National Insurance cuts, granted in the recent Autumn Statement, and the budget in March is widely expected to see cuts to consumer or business taxes or, more likely, both.

The Labour opposition has pledged much more fiscal responsibility than we saw at the last election but it already has some unfunded pledges, such as a GBP28bn Green New Deal and if its large 20-point-plus poll lead over the Conservatives starts to slip there might be pressure to follow the Tories and offer more fiscal giveaways.

We doubt that anybody is suggesting that either party will rip up the fiscal rule book in quite the same way as the brief Liz Truss government did in September and October 2022. Back then the government eschewed both the input of the independent Office for Budget Responsibility (OBR) in the budget process, as well all thoughts of funding the large tax cuts with revenue-raising measures. But the argument goes that investors have long memories and could be put off gilts – and the pound – in a big way if either the Conservatives or Labour push fiscal easing even slightly in the direction of the disastrous Truss-led experiment. So, why don’t we think the doom merchants are correct on this one?

On the Conservative side it was PM Sunak himself who warned during the leadership contest that a Truss-led fiscal splurge would hit UK assets. His warnings proved prescient and presumably one reason why he won’t fall into the same trap. Tax cuts have, and will be granted, but not outside the customary process of involving the OBR and not with the reckless abandon we saw in the mini-budget of September 2022.

As for Labour, it knows full well that it only has a chance of leading the country when it pledges fiscal responsibility. It did the opposite of this in the 2019 election and was trounced. Its leadership is not going to go all wobbly on fiscal discipline now just because the government is handing out tax cuts. But besides the modest fiscal pledges on offer from both parties, there is also the fact that the September/October 2022 run on gilts and slump in sterling was primarily caused by the huge asset disposals forced on the Liability Driven Investment (LDI) sector of the market and pension/insurance funds.

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We don’t want to go over again the specific reasons why the defined benefit pensions sector, and LDI in particular, proved so vulnerable as gilt yields started to rise, but we’d be reasonably confident that lessons have been learnt and vulnerability has been reduced. Of course, this is not to say that gilts and the pound are totally immune from weakness created by injudicious fiscal promises and policies; just that a September/October 2022-style rout seems very unlikely.

In fact, in some ways that whole crisis could turn out to be beneficial in the future, at least for the pound. This is because there are serious proposals to eliminate both the hefty concentration in the LDI sector around a small number of firms, and the significant bias within defined benefit pensions towards holding gilts over other assets, such as equities. The government is looking into this and with the proposals coming from former Labour PM Blair, we dare say they are of interest to Labour as well. These proposals talk to the general feeling in the UK that the stock market is badly underperforming in part, because the defined benefit pension sector is almost forced to put all its eggs in the gilt basket.

If, through legislation, this can be changed, alongside other measures to make UK stocks more attractive, such as restricting the tax advantages of Individual Savings Accounts (ISAs) to domestic stocks only, it is possible that the much-undervalued stock market could start to outperform – and this, in turn could help sterling to avoid falling into the watery grave that some have in mind for this year.