Legend has it that summers used to be quiet in financial markets.

‘Sell in May and go away’, as the saying goes.

So far, the summer holiday has been on hold. Who needs the beach and a good book when you’ve got high drama in government bond markets?!

Never fear, once the markets settle after a busy early summer you can sit back and relax. Let us take you through our summer book review of markets, complete with scheming, plot twists and even a happy ending for fixed income markets.

In the UK – One Hundred Years of Solitude

This tells the story of the rise and fall, birth and death, of the mythical town of Macondo (or, in the UK, the Conservative Party).

The Conservative Party has consigned itself to solitude. It was a long shot to call an early election and it failed miserably. Although maybe not 100 years, the Conservatives will need considerable time in quiet contemplation to understand what went so wrong over the last five years.

As we noted in an earlier article (Ah, politics – we’ve been expecting you), markets need not fear a Labour administration. It was an incredibly dull election campaign and we don’t think we learned anything that changes our original view.

The one thing we perhaps didn’t expect was the sheer size of Labour’s majority. Does that change anything? Will the Labour Party now be more fiscally expansive than promised? That’s a Catch 22. The electorate might want it, but markets don’t – and markets are in the driving seat for the time being.

We expect the first big fiscal event will be delivered in October. A key line in the Labour manifesto stated that ‘the fiscal rules are non-negotiable’. The Labour Party’s fiscal rules (which are very similar to the Conservative Party’s fiscal rules) mean spending headroom is close to zero. Any new outlay must be matched by increased tax revenue.

The Labour Party has a medium-term plan, and to deliver that it needs financial markets to believe its story. Any perceived short-term gain that turns international investors away from the UK (and raises the cost of borrowing) would be inadvisable.

Bank of England (BoE) Governor Bailey has come back from his enforced solitude (election purdah). We did expect a rate cut in June, which he didn’t deliver. The lack of downward movement in services inflation and the election put paid to that idea. However, the BoE is still primed and ready to go. The cutting cycle has simply been delayed until August.

A boring Labour government and a dovish BoE is exactly what the gilt market needs. The last few years have been a wild ride, whether it be politics, monetary policy or even the UK’s inability to compile labour-market data. If the Labour Party plays its cards right, international investors can gain confidence in this new-found political stability. Even better, for the first time, UK yields look appealing relative to Europe and the US.

In Europe – The Art of War

This concise read offers ancient wisdom on how to use skill, cunning, tactics and discipline to outwit your opponents.

Only time will tell if President Macron’s (potentially) cunning and discipline will have outwitted Marine Le Pen. The battle was this summer’s legislative election, the war is the presidential election in 2027.

Is this a France-specific mess or a Europe-wide calamity? The answer? It’s a French bordel. A market catastrophe has been avoided with the second round results. However, the true test will come in the autumn. The French will have to make some tricky decisions about spending cuts. A new coalition government isn’t going to make that any easier.

After the first round of voting, it seemed inevitable that Le Pen (and her far-right party) would play a major role in running France. That would have meant, for the first time, facing the tough reality of day-to-day governing. Those decisions will likely be owned by the centre left. We expect a challenging three years leading up to 2027, both to enact the required significant spending cuts and to remain semi-popular. The real prize for Le Pen or even Mélenchon would be the presidency in 2027.

As a result, French yields should remain elevated, relative to peers, for some time to come.

Over in Frankfurt, the European Central Bank (ECB) stayed quiet throughout the French battle, delivering its first cut in June as expected. European data seem to be showing two stories. On the one side, wages are falling, yet on the other, inflation seems somewhat stickier than expected. The ECB should deliver two more cuts this year, with the next reduction pencilled in for September. However, for this to come to fruition, we need a clearer picture on actual inflation declines, not just economic forecasts.

In the US – Alice Through the Looking Glass

Alice’s second adventure takes her through the looking glass to a place even curiouser than Wonderland.

The first coming of Trump was curious. The second coming of Trump is even curiouser.

An election loss in November 2020 was followed by the 6 January Capitol Building attack. Add in the various court cases and Donald Trump is back – more divisive yet seemingly more popular than ever. On the Democrat side, questions are mounting as to whether Joe Biden should stay in the race. If not, Kamala Harris? Or even more intriguing, how about Michelle Obama as Trump’s opponent?

The US election is going to be key for markets as we head into the end of the year – but not yet. US data is driving markets: the stickiness of inflation data combined with the continued loosening of the labour market are currently holding the market’s attention. Data should allow the Federal Reserve (Fed) to cut in September.

After that, the election will take over. We see three scenarios with different outcomes: full-fat Trump (control of both Congress and Senate), diet Trump (Democrats control Senate), or Trump zero (Democrat win).

All three will lead to different market reactions. As we get closer to the election, we’ll be back with how each scenario plays out in the markets.

Time for a holiday?

Markets seemed to have survived the French election, with the problems stored up for later in the year.

The UK voted in a left-wing government with a large majority and markets didn’t really blink. The first real fiscal test comes in October.

We’ve had the first US presidential election debate, but we’re now on hold until we know who the Democrat candidate will be.

The ECB seems content to wait until September. The July meeting probably comes too soon for the Fed, so we’ll pencil in a September cut. That just leaves the BoE, which if the data plays ball, should pull the trigger in early August.

Markets can maybe relax. Just for a few weeks anyway. Autumn is lining up to be a blockbuster period wherever you look. For now, enjoy your summer holiday and whichever book you decide to dive into. If you have any literary or market questions, please contact abrdn Investments.