Navigating the UK's Fiscal Tightrope
Political attention has recently been focused on party conferences, but it will soon turn to Rachel Reeves and the budget she will deliver on 26 November. With a large fiscal deficit once again being discussed, further tax rises are expected from the government. This comes despite last year’s tax hikes being billed at the time as a one-off. So, why are we back here again?
The answer is necessity. A tough economic environment has collided with political miscalculations, meaning that public finances remain stretched. UK debt is currently near 100% of GDP, which is the highest level since the 1960s. The cost of servicing that debt is a growing burden on the Treasury, as old maturing bonds must be replaced with new borrowing which is only available at higher interest rates. With the question of debt sustainability increasingly being asked, Reeves is under pressure to act decisively or risk a backlash from the bond markets.
Should large groupings of investors lose faith in the Chancellor’s plans, then falls in government bonds and the pound could occur. The actions of these “bond vigilantes” can bring down a government, as Liz Truss can attest to after the unfunded tax cuts of her 2022 “mini-budget” caused panic in the markets and ushered in her departure from Downing Street. While Reeves will not follow Truss on unfunded tax cuts, if she pursues unfunded spending – as some on the left are calling for, such as Andy Burnham recently stating that the UK should not be beholden to the bond market – then the results could be similar. Clearly, she is keen to avoid this scenario.
There are three main ways the government could reduce public debt: engender economic growth, cut spending, or increase taxes. Unfortunately, her options are limited. The UK economy is subdued, and resistance from within her own party to welfare reform shows large spending cuts are unlikely. That leaves tax rises as the most likely route to balance the books.
Reeves and Starmer have been hamstrung by their manifesto pledge not to raise taxes on working people. In last year’s budget, they managed to avoid breaking the letter of this law, but the spirit of it was clearly sacrificed, with the national insurance contribution rise an additional burden for business, which ultimately has impacts on the labour market. Nonetheless, that is the decision they felt they had to take to win the election, and they must now face the consequences.
Many economists will argue that an increase to income tax rates would be the fairest and most effective way of raising additional tax revenue, yet this choice would be a hard sell to the electorate, who would view it as another broken promise, further denting confidence in mainstream politicians. The Chancellor therefore faces a series of tough decisions for the Budget. Higher taxes on individuals will damage popularity amongst voters. Yet, saddling business with the bulk of the tax hikes could further suppress economic growth, making it even more difficult to hit her fiscal targets in the future.
Bond Strategy Amid Fiscal Uncertainty
In light of these challenges, how should investors position their bond portfolios?
In the investment portfolios managed by Future Money, there is currently a bias towards short- to medium-dated UK government bonds. These are likely to benefit if interest rates gradually fall over the coming years, especially if inflation eases and the Bank of England begins to loosen policy. However, the portfolios remain underweight in long-dated gilts. These are more vulnerable to shifts in market sentiment and could suffer if concerns about the UK’s creditworthiness resurface.
The risk of a repeat of the Truss-era gilt crisis is not negligible. Any sign that the government is losing control of the fiscal narrative could trigger a sell-off, particularly in longer maturities where sensitivity to borrowing costs is highest.
Six Months After Trump’s Tariffs: A Surprising Market Resilience
It has now been six months since Donald Trump’s so-called “Liberation Day” tariff announcements. These initially sent global markets into a tailspin, yet conditions since have been relatively benign for investors.
Bond markets have remained flat, with concerns over government borrowing balancing the positivity from gradually falling interest rates. Equities, in contrast, have rallied strongly. Despite being the most obvious targets of Trump’s protectionist rhetoric, Asian and Emerging Market equities have led the charge, as improving economic performances have combined with moderate valuations to more than offset the risk to trade from Trump’s tariffs. US equities too have performed well, buoyed by continued performance in large-cap technology stocks, while UK and European markets have also posted solid gains.
A significant part of the strong performance of non-US markets can be attributed to a weaker dollar, as the funding cost for dollar-denominated borrowings has lowered. Trump’s tariffs, combined with his attacks on institutions like the Bureau of Labor Statistics, have eroded confidence in the US as the anchor of global trade and monetary stability, while his attempts to control/influence the Federal Reserve have led to an assumption that US interest rates will also be lower than they otherwise would be – a further reason for the dollar to soften.
Risks on the Horizon: What Could Derail the Rally?
It has therefore been a very resilient market, despite the obvious challenges that are present. But there are multiple risks which must be monitored, each with the potential to knock investor confidence.
In the US, a government shutdown is currently underway after Congress failed to pass a federal budget. Around 750,000 public sector workers face furloughs, many of whom Trump has threatened to lay off, and public services are being scaled back. Negotiations are ongoing, and a quick resolution would mean there is little significant impact on the US economy, but with the last shutdown of late 2018 and early 2019 denting economic output, a prolonged impasse could do the same again, potentially hurting investor confidence.
Besides the shutdown, the US economy is already in an uncertain state, as far as the central bank is concerned. Inflation is above target (with Trump’s tariffs a contributing factor), yet the US labour market is showing signs of strain. Job gains have slowed, and unemployment is ticking up. This puts the Federal Reserve in a bind: cut rates to support growth, or hold firm to fight inflation? Trump would rather the former but this would risk a rise in longer-term inflation expectations. In this scenario the bond vigilantes could quickly turn their attention from the UK and towards questions of US fiscal stability.
With equities having performed well in 2025 so far, this further adds to concerns over stretched valuations in parts of the equity market. Technology stocks, and specifically those linked to AI, have performed incredibly well over recent years, but with much of their value built on assumptions of the productivity gains AI will bring – many of which are as yet unproven – these inflated values could become a real problem should delivery underwhelm. While hype continues to build and there are plenty of positive signs to justify it, there are also warnings. A recent MIT report found that 95% of generative AI pilots have failed to deliver meaningful returns, raising questions about the sustainability of the current tech rally. Meanwhile, JP Morgan boss Jamie Dimon has recently warned that investors collectively are underestimating the risk of stock market exuberance around the sector.
Overall, Future Money believe that there are ample opportunities in the market, but with numerous risks a cautious positioning is required. The largest illustrations of this are biases away from long-dated bonds and away from areas of the equity market with the highest valuations.