The Prime Minister’s resignation, taken in isolation, has been digested calmly by markets. This is largely because markets had anticipated the resignation and yields have been increasing over recent months to reflect the associated risks.
You can see from the below chart that UK borrowing costs (as represented by the UK 10-year government bond yield) have increased from a little over 4% to 4.8% today; having peaked at over 5% (with longer-dated parts of the UK government bond market reaching levels not seen since 1998 in May). A significant proportion of this increase has been the result of higher global inflation expectations following the Iran War, with markets adjusting to reflect expectations of higher interest rates in response. Nevertheless, there has undoubtedly been additional pressure here in the UK as a result of the political uncertainty surrounding Keir Starmer’s resignation and, more importantly, the potential choice of Chancellor and approach to government spending and borrowing that may follow.
Source: Factset
In anticipation of the event, we have recalibrated our modelling of fair values for the UK 10-year government bond yield. We focused on the negative reaction to the Liz Truss mini-Budget of 2022 as a reasonable recent stress test and have concluded that even under a more severe scenario such as this, where the incoming Prime Minister and new Chancellor abandon Reeves’ fiscal rules and announce a significant spending package, current yields above 4.8% still represent good long-term value. Accordingly, we have twice topped up our UK government bond holdings when the UK 10-year yield approached or exceeded 5%, as shown above.
We are, of course, continuing to monitor the situation very closely, and have the tools to act quickly should the evidence on the ground changes. For the time being though we believe that uncertainty has created a window of opportunity and we have sought to take advantage of it for clients.
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