6th May 2015
As both Labour and the Conservatives are still neck and neck in the polls and a hung parliament remains likely, Dean Turner and Bill O’Neill, economists at UBS, take a look at the potential election outcomes and what they mean for the UK economy….
The markets are calm …
In the past two weeks, the FTSE 100 has remained close to its all-time high, 10-year gilt yields close to their record lows, and cable (GBPUSD) has moved back to within a whisker of its high point for the year. Altogether it seems that the election is largely absent from investors’ thoughts, which, in itself, is understandable. Although the election may be on domestic investors’ minds, looking at the UK from overseas, things appear a little more robust.
For example, notwithstanding the weaker-than-expected Q1 GDP release, the UK should continue to grow at an above-trend rate this year. We expect unemployment to continue falling; wage growth should accelerate through the second half of the year, and this should prompt the Bank of England to remove some stimulus from the economy in the final quarter. There may be some concern that the election may dampen the prospects for the UK. However, our analysis suggests that the “gap” between major political parties on their fiscal plans is modest: the direction of travel is the same, so the relative impact in the short term should only be marginal.
Complementing the domestic story is the positive outlook for the global economy, in particular, for the UK’s closest neighbor and largest trading partner, Europe. Quantitative Easing (QE) in the Eurozone has coincided with a cyclical upswing in activity, which may well result in 1Q growth printing at the highest level in four years. The pace of growth has slowed a little in the US, but the flip side is that monetary policy will likely remain accommodative for longer, reinforcing the medium-term prospects for the economy.
All things considered, the “bigger picture” continues to be supportive for equities, and the relatively attractive yield on UK gilts should also encourage demand in an environment where QE continues to depress Eurozone government bond yields.
…but not complacent
Perhaps the biggest surprise has been the strength of sterling over the last two weeks. In our view, sterling is the easiest path to follow for investors concerned about the election outcome. To be sure, although cash markets have performed well, this probably has more to do with US dollar weakness (the euro has also risen against the dollar in recent weeks).
Perhaps more interesting is that implied volatility in the options contracts that expire around the election have surged above the levels reached during the Scottish Referendum. Thus, it does seem that investors are positioned for some volatility around the election, so the scope for a sharp, negative post-election reaction looks to some extent curtailed.
Long campaign is watering down main concerns
As we have written previously (see A minority government: how it happens and where it matters), we believe that major policy risks that could impact investor sentiment are centered on an EU referendum (BREXIT concerns), the outlook for fiscal policy, and concerns about further devolution in the UK. While all of these risks remain extremely valid, the lack of momentum in the polls has led to increasingly frantic campaigning, the result of which has been to dilute some of these concerns from an investor’s perspective, as the alternative choices seem less stark:
EU referendum (BREXIT): although this is still likely to be a cornerstone of policy for a Conservative-led government, the absence of a majority suggests that some elements may have to be conceded. The Liberal Democrats have indicated that they may support an EU referendum, making a coalition/alliance feasible. But this support is likely to come with conditions that are likely to favor the UK remaining in the EU.
Our base case remains that, if there were a referendum, the UK would vote for the status quo; this view has only been reinforced in recent weeks. The markets are likely to have come to this conclusion as well.
Fiscal policy: with a number of pre-election giveaways in the final weeks of campaigning, the differences between the main parties’ fiscal policy paths look increasingly small. Moreover, as has recently been highlighted by the Institute for Fiscal Studies (IFS), all parties’ plans for deficit reduction look quite questionable: A number of bold tax and spending plans lack sufficient detail. Thus, whoever leads the next government, fiscal slippage against current targets seems inevitable. From a market perspective, the difference between the plans offered by a Conservative/Liberal Democrat or Labour/SNP government look less stark in the short term. These policies could alter the rate of growth and the path of interest rates, but our sense is that this will only be marginal over the next 12-18 months.
Devolution: The SNP has strong support in Scotland, and the party is likely to win over 40 of the 59 seats they are contesting, making their calls for further devolution of powers to Scotland inevitable. We don’t think devolution will be an immediate concern for markets but it could become one as the elections for the Scottish Parliament approach (scheduled for 5 May 2016). Concerns will no doubt be focused on potential for another Scottish Referendum, but the probability of this is still low, in our view. SNP leadership has tried to distance itself from this in the current campaign, given that they lost the recent referendum. Sentiment can obviously change, but we feel that calls for another referendum are unlikely before campaigning for the Holyrood 2016 ballot begins. Other risks may become apparent once the results are in.
Markets are not fully prepared for drawn out negotiations
The uncertainty surrounding the election seems to be well understood by markets. However, our sense is that markets are not prepared for an outcome that is extremely close or for the prolonged negotiations that would ensue.
The waters have been further muddied by the recent announcements from the main parties as to whom they would “deal” with after the election.
The Liberal Democrats have indicated they would be unwilling to work with any government that is “propped up” by the SNP. Furthermore, they have stressed that a government led by a party without the largest number of seats or the majority of the vote would lack “legitimacy,” and the electorate would question such a government’s “birth right.” Taking current projections based on the most recent polling, this would suggest that they would only be able to support the Conservatives (the largest party), potentially removing one option of support for Labour. The Labour party has already ruled out a formal coalition with the SNP.
They have been pushed further on this matter, and party leader Ed Miliband stated “no coalition, no tie-ins, I have said no deals; I have been clear about that … I am not doing deals with the SNP.” Although this statement seems pretty emphatic, circumstances can quickly evolve, and we continue to assume that the SNP will support any attempt by Labour to form a government. And since the SNP has categorically ruled out supporting a Conservative government, it seems they have no other choice.
Any combination of these parties supporting a Labour minority would be enough to give them a working majority; however, support may be harder to obtain than is initially assumed.
In our view, this all suggests that, barring any last minute swings in the polls, the risk of protracted negotiations to form the next government is high. The longer this process takes, the more unsettling it will be for investors.
The campaigns so far have not been a huge success for either of the major parties. Both have failed to make significant headway in the polls, and the result is that a hung parliament is the most likely outcome.
Campaign promises have likely dampened some of the policy risks associated with either option of government (Conservative or Labour), but the risk of prolonged negotiations after the election is under-appreciated, in our view.
For us, the best outcome for markets will be a swift and conclusive outcome after 7 May. The alternative will be unsettling for markets and sterling is likely to be left exposed.