A surge in the opinion polls by the opposition Labour party is forcing investors to pay more attention to a UK general election that was expected to be a stroll for Prime Minister Theresa May and the Conservatives.
With the campaign entering its final stages before the vote on June 8, we examine how sterling, UK government bonds and FTSE-listed stocks are likely to trade as the result emerges and in the days that follow.
Election night, June 8
The FTSE 100, which has benefited from the pound’s weakness since the Brexit vote, sits just shy of record high. Meanwhile, the yield on the 10-year gilt sits at about 1.02 per cent, down from a recent high of 1.20 per cent a month ago, as bond investors digest a run of lacklustre UK economic data.
The first clear indication of which way the British electorate is leaning will come shortly after 10pm local time, when the official exit poll is published. Historically reliable, the exit poll is a much more extensive piece of work than the pollsters’ efforts during the campaign.
Foreign exchange traders will respond to this, as well as the early results from specific constituencies, in the less liquid Asian markets. Reaction to the EU referendum result was extreme — sterling plunged 13 per cent within six hours of the polls closing as investors discounted a more difficult economic future for the UK.
While the pound is likely to trade sharply, currency strategists say it would take a surprise outcome — something other than a majority for the Conservatives — to eject sterling from its recent trading range of $1.28 to $1.30.
Given the closeness of the polls, analysts at JPMorgan Chase forecast a “relief rally” of between 1 per cent and 2 per cent if the Conservatives increase their parliamentary majority from 17.
June 9 — the morning after
As the Tories’ lead in the polls has shrivelled, investors’ attention has focused on what various outcomes might mean for Britain’s EU exit negotiations, which are due to formally start on June 19.
David Owen, chief European economist at Jefferies International, argues that “compared to a week or so ago, a working majority of 40 would probably be seen as a good result for Theresa May”. However, even with that outcome “her authority has undoubtedly been weakened by the campaign”, raising doubts about her ability to deliver a good outcome from the talks with the other 27 EU countries.
While the central projections are for a Conservative majority of between 40 and 70 seats, the prospect of either a hung parliament or even a shock Labour win cannot be disregarded.
The pound will drop to about $1.25 if the electorate defies the polls and prevents the Tories from securing an overall majority, according to ING. Underlining the disagreement in the market over what certain outcomes would mean, ING says that even a 50-seat majority will trigger a negative reaction in sterling. A majority above 130 would lift the pound to $1.32, they say.
UK stocks are likely to take their cue from the pound. The weakness in the pound since the Brexit vote has sent the FTSE 100, whose member companies generate about 70 per cent of their revenues overseas, to record highs.
For UK government bonds, a weaker showing by the Tories that leaves them with a majority of fewer than 20 seats would send the yield on 10-year gilts up 5-10 basis points, according to JPMorgan. A hung parliament or coalition would add 10-20bp, while a Labour majority would see 30-50bp added to yields and a “substantial sell-off,” they argue as investors digest the party’s fiscal plans.
The consequences of the election could go down one of three broad paths: if the Tories were to lose their majority, the two biggest parties could engage in horse-trading to negotiate a coalition — something that may drag out over weeks.
The fallout of a Labour win would be a short, sharp decline in sterling, and drops in UK stocks, particularly utilities and banks, says Kathleen Brooks of City Index. Analysts at Goldman say that while Labour’s plans for fiscal stimulus should help the FTSE 250’s mid-cap companies that depend on the UK economy, the initial reaction is likely to be a negative one.
In the much more widely expected outcome of an overall Conservative majority, Mrs May will contemplate a Cabinet reshuffle that would set the tone for the Brexit negotiations. If she rewards Brexiters, a tougher stance in the negotiations would hurt the pound, says ING. A more centrist cabinet and a more diplomatic Brexit tone could well drive the pound up to $1.33.
The paradox for investors seeking a ‘softer’ Brexit in which the government’s priority is retaining as much access to the single market as possible, a prime minister weakened by the election outcome might turn out to be preferable. “Theresa May’s position as PM may be questioned, which could lead to markets pricing in some chance of a ‘softer’ Brexit,” say strategists at JPMorgan.
The negotiations will not be plain sailing, Jefferies’ Mr Owen warns. “We still do not know exactly what form of Brexit Theresa May is aiming for or whether an acceptable compromise can be reached in the timeframe allowed,” he says.
As a result, investors will continue to face distractions from more familiar and comfortable territory. “Every minute an investor spends on politics is a minute they could have spent better understanding company and industry fundamentals and valuations,” says Matthew Jennings, an investment director at Fidelity International. “Over longer timeframes, these have a far more significant impact on returns than politics.”