Political turbulence leaves gilts exposed

Highlights: Political uncertainty in the UK has added another layer of volatility to the already fragile nation’s macro backdrop. Markets are increasingly questioning the government’s fiscal credibility following local election setbacks and growing speculation around a potential Labour leadership contest. At the same time, higher oil prices linked to the prolonged Strait of Hormuz disruption are feeding through to inflation expectations, limiting the Bank of England’s flexibility to ease policy despite weakening domestic growth signals. Consumer confidence remains subdued, house price growth is stagnating, and job vacancies continue to trend lower, pointing to softer demand conditions across the economy.

• The gilt market has become particularly sensitive to this combination of political instability, inflation risks and foreign investor positioning. Rising volatility in UK government bonds, alongside the increasingly negative correlation between GBP and gilt yields, suggests overseas investors are playing a larger role in recent market swings. While current volatility is still below the extreme levels seen during the 2022 mini budget episode, the market sentiment remains uncomfortable given the UK’s fiscal constraints and dependence on more price sensitive investors. Longer-dated gilt yields have risen sharply, reflecting both inflation concerns and the uncertainty premium currently attached to UK assets
• Looking ahead, the direction of gilts will likely depend on whether inflationary pressures from energy prices begin to ease soon and whether the political backdrop stabilises. In the near term, markets may remain cautious as they assess the balance between slowing growth and persistent inflation risks. However, elevated long term gilt yields could be attractive from a longer-term perspective, especially if weaker economic momentum eventually pushes inflation and policy rates lower over time
• Portfolio implications: We remain neutral on UK equities given the challenging domestic backdrop and ongoing political uncertainty. The deteriorating growth and fiscal picture in the UK – driven by political uncertainties alongside inflationary pressures linked to the ongoing closure of the Strait of Hormuz could likely remain a headwind for gilts. Elevated volatility may persist in the near term, but longer duration bonds increasingly offer attractive income opportunities if growth slows further and inflation pressures moderate. We remain constructive on inflation linked exposure as a hedge against continued energy-driven price risks