Political turmoil returns to the UK! Investors, worried about a sharp left turn and the return of radical fiscal policies, are accelerating their exit from pound assets.

Political turmoil returns to the UK! Investors, worried about a sharp left turn and the return of radical fiscal policies, are accelerating their exit from pound assets.

Political power transition risks in the UK are pressuring the financial markets. The market’s expectations of an internal Labour Party challenge against current Prime Minister Starmer are rising, with the pound falling to a near one-month low and 10-year gilt yields breaking above 5%. Investors are repricing UK assets, with the core concern being a potential loosening of fiscal discipline.

On Friday, Greater Manchester Mayor Andy Burnham qualified for the Wigan constituency by-election, removing procedural barriers to his bid for the Prime Minister position. Previously, Starmer’s camp had blocked his candidacy in January. The opening of this by-election route comes as Labour suffers a disastrous local election defeat and Starmer faces pressure to resign, prompting an immediate market response. Data shows the pound fell 0.3% against the dollar to 1.3363, extending a week-long decline; 10-year gilt yields rose more than 1 basis point to 5.137%, remaining at elevated levels within the G7.

Investors broadly worry that if Burnham takes office, his policies may shift “left” — expanding government spending, relaxing fiscal discipline, and increasing public borrowing — potentially breaking the current government’s fiscal restraint framework. Paul Markham, Head of Global Equities at GAM, describes this as a “toxic combination”: rising bond yields and a weakening pound are typical price features when fiscal credibility is questioned, more common in emerging markets than developed economies.

Burnham Effect: Market Reprices UK Fiscal Credibility

Burnham’s statements have directly triggered market concerns. Last year he openly criticized the UK government for being “held hostage by the bond market”; last week, he proposed that defense spending should be accounted for separately from fiscal rules, further fueling expectations for a substantial increase in gilt issuance if he takes office. Although he partially softened his tough stance toward bond markets in February this year, stating “bond markets should not be ignored,” Deutsche Bank analysts believe this is insufficient to ease market doubts.

Prediction market Polymarket shows Burnham has become the most likely candidate for the next UK Prime Minister, with a probability of 42%, much higher than Starmer’s 27% chance of retaining his position. Poll data also indicates 61% of Labour Party members support Burnham, while only 28% back Starmer.

BBH Global Market Strategy and FX Director Elias Haddad said a Labour government under Burnham’s leadership will probably bring more spending and borrowing, while current UK nominal GDP growth is already lower than 10-year gilt yields, making it increasingly difficult to contain debt growth. He predicts, “UK fiscal credibility is deteriorating, with outlook for both the pound and gilts remaining downward.”

RBC BlueBay Macro Portfolio Manager Neil Mehta points out that the next Labour leader will come from the party’s left wing, “UK financial assets and the pound will face elevated political risk premium for a considerable time.”

Stock Market Under Pressure, Domestic Assets Hit Hardest

The stock market is also impacted, especially sectors relying on domestic policy and economy. A Goldman Sachs strategist Sharon Bell’s team notes amid policy uncertainty, UK domestic banks, domestic stocks, and small caps bear the highest risks, while real estate is particularly sensitive to rising yields.

Rich Privorotsky, head of the One-Delta trading desk at Goldman Sachs, points out that the market will naturally start to consider whether future leadership changes mean a reshuffling of fiscal priorities, spending plans, and tax policy. The UK gilt market will continue to serve as an important “barometer” for testing fiscal credibility.

However, the market has already priced in a substantial degree of negative news. The forward PE ratio of the FTSE 250 is about 12x, below historical absolute and relative averages, and the FTSE 350 is 35% cheaper than global counterparts. Goldman strategists note the real estate sector’s dividend yield is roughly 200bps higher than the market average, comparable to deep recession levels during the early 1990s and the global financial crisis. If gilt yields eventually retreat from high levels, this sector will be a clear beneficiary.

The FTSE 100, supported by a high proportion of commodities and defensive assets, has outperformed the FTSE 250 so far this year. However, Goldman believes as the Iran conflict eases, this advantage may narrow; since the ceasefire in early April, the index has essentially traded sideways.

Political Uncertainty and Macro Pressures Resonating

Political risk is not the only variable facing UK assets. JP Morgan strategist Davide Silvestrini’s team highlights the dual pressure on UK assets from both energy price shocks triggered by the Strait of Hormuz situation and domestic political uncertainty.

Latest PMI surveys show UK’s private sector in April suffered a dual blow from surging energy costs and weak demand, making the Bank of England’s policy stance even more difficult: the energy shock may drive up inflation while weakening demand raises downside economic risks. The bond market currently expects the BoE to hike rates two to three times in the next 12 months, further limiting downward space for yields.

Former UK diplomat and House of Lords member Peter Ricketts points out that domestic political “court drama” will harm the UK’s international reputation and influence. He believes if Starmer has to fight for his political survival, his effectiveness in coordinating Europe on Ukraine and Iran crises will be greatly diminished, and the EU is unwilling to negotiate closer relations with a UK where the Prime Minister’s future is uncertain.

AJ Bell Investment Director Russ Mould adds that the UK is about to welcome its seventh Prime Minister in ten years, “this is not a record to be proud of for any country,” and is one reason why UK 10-year gilt yields are high among the G7.

Risk Warning and DisclaimerThe market has risks, investment should be cautious. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial situation, or needs of any individual user. Users should consider whether any opinion, viewpoint, or conclusion in this article fits their particular circumstances. Invest accordingly and bear responsibility for your own decisions.