6th May 2015
Ugo Lancioni, Portfolio Manager, Global Fixed Income and Currency at Neuberger Berman gives his view on the UK and the election.
The U.K. is about to vote in one of its most consequential and unpredictable elections in recent memory. However, investors concerned about their sterling exposure should keep their eye on the big picture.
In Hollywood movies, when the world teeters on the edge of some epochal event, newspaper editors send different versions of the next day’s front page down to the print room, each reporting the different possible scenarios. It helps ratchet up the tension. The same kind of tension is taking hold around the U.K.’s current general election campaign: The polls open on Thursday and the electorate faces similar double- triple- or quadruple-front page uncertainty. At the very least, this election feels like the country’s most consequential and unpredictable in recent memory. But should we assume that it will therefore have a decisive impact on financial markets, and in particular on the pound sterling?
Volatility, but No Clear Direction
The polls have been steady for some time. The question is not who is going to win—no party is likely to win—but rather who will be able to form a coalition or support a minority government. And the permutations are uniquely wide for the U.K., especially following the extraordinary surge in support for the Scottish Nationalist party (SNP), a left-wing separatist party that looks set to all but wipe out the Labour party in Scotland and prevent it from achieving a governing majority. Probabilities are almost equal that the U.K. could see a continuation of the past five years’ coalition between the Conservative and Liberal Democrat parties; a Labour minority government supported by SNP MPs on crucial votes outside a formal coalition; or a new coalition led by the Conservatives, who have made a campaign pledge to hold a referendum on the U.K.’s membership of the EU, with smaller parties further to the right that are even more euro-sceptic.
This means we will not have a really clear idea about the U.K.’s fiscal plan, an important domestic factor for sterling, for days or even weeks after the polls close. This makes for high levels of uncertainty in markets but no particular sense of which direction sterling might take once the results are in.
We can see this in FX options. Consider how one-month volatility in the pound/U.S. dollar trade (GBP/USD) is being priced relative to one-year volatility, for example. This reflects higher demand from investors buying options to protect their portfolios in the near term—highlighting that this demand is linked to near-term idiosyncratic event risk. Demand for longer-term protection has remained relatively stable. The difference between near- and long-term volatility pricing has reached levels comparable to those realized during the run-up to the Scottish independence referendum of 2014, when the very existence of the U.K. hung in the balance. Markets expect that there may be big sterling moves around the election.
But those same markets are not expressing a similarly strong view about which direction that volatility might take. Look at so-called “risk reversals,” which show the difference between the implied volatilities of call options and put options with the same delta. When the Scots looked like they might leave the Union, the skew to put volatility became extreme: There was no doubt the market thought this outcome would be bearish for sterling. Today, while elevated, GBP/USD risk reversal is nowhere near those levels.
Sterling Is Already Weaker
Of course, the outlook for where you are heading depends partly on where you are now. Until two weeks ago, sterling had been quite weak against the dollar but strong against the euro. More recently, it has been depreciating against the euro. To put it simply, a certain amount of downside has already been priced in.
We don’t need to turn to the general election to explain that downside: While it remains one of the better economic performers, recent data out of the U.K. has been soft. Q1 GDP growth clocked in at 0.3%, versus a consensus forecast of 0.5%. The manufacturing PMI from Markit fell to 51.9 for April, versus a forecast of 54.6 and down from 54.0 the month before—a figure itself revised down from 54.4.
Moreover, there are reasons for optimism on sterling. The eurozone is due a bit of catch-up, and evidence of an improving situation there and the positive impact expected from the ECB’s QE may account for sterling’s recent weakness against the single currency. However, in the longer term, this should be positive for both sterling and the U.K., a very open economy heavily exposed to European demand, as long as the new government positions the country to capture the opportunities that come from recovery on the continent.
Don’t Forget the Big Picture
There is one tail risk hidden in this election, of course: the referendum on EU membership that becomes highly likely in the event of a Conservative-led government. However, even that would still be months away, and unlikely to move markets in the immediate aftermath of Thursday’s vote. And ultimately, the openness of the U.K. economy that makes the EU referendum significant also explains why even the bearish risks to sterling come from outside the U.K. rather than within—things like global volatility following the first U.S. rate hikes, Greece falling out of the eurozone, or rising geopolitical tensions to the south and the east.
It’s very easy to get caught up in the excitement of an election campaign, especially one as open as this one has been. However, investors shouldn’t forget the big picture: Volatile as this election may be for U.K. politics, it comes during a period of heightened uncertainty in world events, the global economy and financial markets. There might be a front-page story that affects sterling this week, but it’s just as likely to have emerged from some event in global markets as from who has won the most seats at Westminster.