Beyond Bulls & Bears

Fixed Income

A Look at the UK’s Post-Election Scenarios

The UK general election campaign is entering its final stages. Opinion polls and market sentiment suggest the Conservatives could be on course for victory, but the result is far from being a foregone conclusion. Our Head of European Fixed Income, David Zahn, examines some of the possible scenarios and considers how financial markets might react.

As the United Kingdom’s general election campaign enters the final few days, investors are starting to get a sense of the possible post-poll scenarios.

The currency markets seem largely convinced that the Conservatives are on course for victory and the Brexit withdrawal agreement Prime Minister Boris Johnson negotiated will pass in short order. Opinion polls generally support that thesis.

Bond yields have been volatile during the campaign—selling off but bouncing back in recent weeks. That reflects both what’s happening in global bond markets, as well as the fact that the Conservative election manifesto was more conservative (with a small-c) than some commentators had imagined.

Generally, we think a Conservative victory is the result financial markets will most likely deem positive.

A hung parliament, in which no party has a majority, remains a distinct possibility if anti-Conservative forces vote tactically in pivotal seats. That outcome, which would bring significant uncertainty, would likely provoke a very negative reaction from financial markets.

Most serious political commentators have ruled out an outright Labour victory, but if we’ve learnt anything in the last three years, it’s be prepared for every eventuality.

Focus on Manifestos

Before campaigning started, there was a lot of speculation about manifesto promises and post-election giveaways. The Labour Party manifesto lived up to expectations in that regard. It is promising widespread nationalisation and massive spending plans across a wide range of fronts.

The Conservatives, by contrast, are traditionally a party of lower taxes and lower government spending. But the Conservative manifesto for this election has diverged dramatically from that playbook.

The Conservative Party seems to have compiled a deliberately boring manifesto to ensure it doesn’t alienate would-be voters. More radical policies might emerge in the future.

The central tenet of the Conservative manifesto is “getting Brexit done”. Its ambition is to push the Withdrawal Agreement Boris Johnson negotiated through Parliament as soon as possible, allowing the United Kingdom to leave the European Union (EU) by the end of January 2020.

The manifesto is not promising tax cuts—at least not immediately. It is, however, vowing to increase spending on popular areas such as the National Health Service and policing.

Our analysis suggests financial markets are likely to look more favourably on an approach that removes some of the current unknowns while increasing government spending by a manageable amount.

Addressing Brexit Questions

In our view, market relief at a Conservative victory may be quite short-lived as investors pivot quickly to think about what’s next—particularly with Brexit.

Once the EU withdrawal agreement passes Parliament, the United Kingdom enters a period of negotiations on a future trade agreement. That negotiation process can last up to 11 months, which we don’t reckon gives much time for the complex discussions required. We don’t think the EU negotiators will be as amenable as they were when agreeing to the withdrawal agreement.

There are a lot of sticking points, with fishing rights being a potential pitfall. There will be some room for negotiation, but we think talks will likely be robust.

If the UK government wants to extend the negotiation period, it needs to make a request by the summer. That really compresses the timetable to just four or five months in which to calculate whether there is a viable trade deal.

If there are no signs of early breakthroughs, we’d expect the markets to start wondering whether a damaging no-deal Brexit is back on the cards. Markets are likely to start reflecting more uncertainty if there are no signs of progress by the start of the summer.

The market’s biggest fear would probably be a hung parliament, which brings heightened uncertainty.

Attention would centre on the likely makeup of any coalition government. Given the campaign rhetoric, the only possible coalition we can imagine would be between Labour and the Scottish National Party. If that were to emerge, we’d expect moves towards a further Scottish referendum and a more opaque Brexit outlook.

In that type of coalition environment, the pound would likely decline and gilt yields rally. We think credit would likely decline.

An Outright Labour Victory?

We believe an outright Labour victory would be a real shock for markets, and we’d expect a very negative response—at least initially.

In the immediate aftermath, the pound would likely fall dramatically and all financial assets would likely decline, reflecting fears the UK economy could head into recession as quickly as the first quarter of 2020.

Uncertainty would likely reign amid concern about rising taxes and imminent nationalisation of utilities and services.

After the initial kneejerk reaction, we think markets should stabilise once investors recognise the new government is unlikely to be able to carry out its most extreme pledges. In that respect, we’d see any selloff in gilts as a potential buying opportunity.

Separately, the whole Brexit process would slip back into limbo. Labour has indicated its intention to negotiate a new withdrawal agreement, which effectively takes the whole saga back to square one.

 

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments.

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