The UK General Election will be held tomorrow. The polls close at 10 pm. We should have a pretty clear picture of the overall seat count by 5 to 6 am on Friday morning. The result, as SocGen notes, is almost certain to be a hung parliament.
Then the fun will really start.
The leader of the incumbent Conservative/ Liberal Democrat coalition (David Cameron) stays in power until or unless it becomes clear that he does not have the ability to form a new government. Most polls are showing that the Conservatives will win the most seats but fall far short of an absolute majority. That will then lead to a contest between them and the Labour party to negotiate with the other parties to form some type of formal or informal coalition. The first test of the new government will be the vote on its legislative programme which is then presented in the Queen’s speech (tentatively scheduled for 27 May). That vote should be in the early part of June.
The main concern for the markets should be whether or not a Conservative-led coalition is formed that is sufficiently supportive of the Conservative’s plans to allow them to hold the promised Brexit referendum by the end of 2017.
Here are the possible outcomes (along with SocGen's probabilities)...
As a reference, here are 2010's results:
And here are the key features of tomorrow's election relative to that result...
1) A reduction in Conservative seats and an increase in Labour seats;
2) A major fall in support for the Liberal Democrats who could easily see the number of seats won fall to less than 30;
3) A surge in the SNP seats from 6 to maybe even more than 50;
4) The poor performance of the UKIP (UK Independence Party), despite its heavy influence on Conservative party policy in recent years. As the chart above shows, they won NO seats in 2010. They currently have two seats as a result of defections from the Conservative party but they will be lucky to win even one more seat than that. So, in the absence of the most unlikely outcome of the Conservatives being only one or two seats short of a stable government, UKIP would have no role in the formation of the next government.
The opinion polls show Conservative and Labour to be neck and neck
SocGen concludes, there is a real choice between the broad fiscal plans of the Conservative and Labour parties.
Labour would cut the deficit more slowly to allow a higher level of net investment than the Conservatives plan. That is a defensible position, worthy of debate at a time when financing costs are at record lows.
However, the key point for the markets is that both major parties have plans to continue austerity at a pace that would satisfy the markets. Certainly, the Labour party has been accused of being anti-big business but that is something that, if true, would only have a gradual impact on the economic future of the UK.
More immediately worrying for the financial markets would be if the Conservatives were able to construct a form of coalition that allowed them to deliver the promised Brexit referendum by the end of 2017. That would create lasting uncertainty that could damage business and investor confidence.
Deutsche Bank believes UK politics alone are unlikely to derail the recovery or meaningfully change foreign appetite for UK assets, in the short term at least and lays out 7 predictions for post-election UK...
Rather than try to guess the outcome, however, in this note we make a few broad brush predictions about what the post-election UK will look like for investors. Our conclusion is that while the politics is extremely uncertain, the policy mix may undergo less rather than more change. Politics alone are unlikely to derail the recovery or meaningfully change foreign appetite for UK assets, in the short term at least.
For GBP, once the initial uncertainty over government formation has passed, the focus should quickly turn back to the monetary policy outlook. On that front, we still see the risks lying in earlier rate cuts from the Bank of England than the market expects. For this reason we see value in using election uncertainty as an opportunity to position into EUR/GBP shorts.
Prediction #1: Fiscal policy will be easier, but the deficit will fall
At the Budget in March, forecast tightening over the next five years fell from 5.5% GDP to 4.4% as the coalition abandoned its goal of a GBP 23bn surplus by 2019-20, but the next two years were still projected to be roughly as austere as at the start of the coalition.1 After the election, there is reason to think this may change.
In the first place, Labour policy is less tight than implied by current forecasts. As the IFS notes, the party’s plans mean only moderate reductions in departmental spending may be required. Under the increasingly likely probability the SNP holds influence over the next parliament, policy could be easier still. The party currently advocates rises of 0.5% public spending in real terms. Note that even under SNP plans, Treasury analysis suggests that the deficit would continue to fall.3 If the Conservatives were to remain in office, current forecasts may not materialize. The party eased off austerity in the middle of the last parliament as growth suffered, and there are question marks over where additional cuts implied by their deficit plans will come from. The party may also be helped by the improving growth outlook. Receipts have started to improve in recent months, and the OBR’s current growth projections are on the pessimistic side of official forecasters. In sum, and as our economist has noted, it may be helpful to look through the very noisy political debate on the deficit, and focus instead on the underlying improvement in the public finances. This has important implications for sterling, because the Bank of England’s inflation and growth projections as of the February Inflation Report are currently predicated on the very austere fiscal path outlined in the December Autumn Statement. Easier fiscal policy should provide the bank with more scope for monetary tightening.
Prediction #2: There will be no fiscal crisis, whatever the outcome
Even if fiscal policy were loosened, there seems little chance of a fiscal crisis. In the first place, the structural deficit has halved over the last five years. Perhaps more importantly, the markets’ understanding of fiscal risks has moved on since 2010, when a genuine loss of investor confidence in the UK finances was arguably on the cards. As the Eurozone crisis has shown, debt and deficits are much more relevant when countries lack an independent monetary policy. A lack of market concern is reflected in credit spreads, which remain at pre-crisis lows. Third, the external environment is very favorable for UK assets. The ECB’s QE program had driven yields of core fixed income negative across the curve. One of the obvious beneficiaries should be the UK. The spread between 10-year UK and German yields is currently the widest on record. Today’s Bank of England data showed massive (GBP 26bn) foreign buying of gilts in March, more than reversing outflows in the first two months of the year.
Prediction #3: The UK will remain one of the most attractive destinations for foreign investment
The last few years have been very positive for foreign investment. FDI inflows to the UK have totaled over 8% of GDP since the fourth quarter of 2012, financing around half of the current account deficit. The policy mix has played an important role. The corporation tax rate has fallen from 28% to 21% over the last five years, seeing the UK leapfrog above every OECD country save Switzerland in terms of corporate tax competitiveness. On the margin, a Labour-led administration would imply a moderately less positive investment climate than a Conservative one, but the policy mix is not set for wholesale change. The party favors keeping the corporation tax rate at its current low level (against another 1% cut proposed by the Conservatives). We doubt that other Labour party policies such as a mansion tax, changes to the non-domicile status of taxpayers and rises in the top rate of income tax, will result in a foreign exodus. Significant changes to the tax treatment of non-doms and foreign purchases of UK property were made by the current coalition government over the last five years with no apparent effect on foreign investors’ appetite for UK assets.
Prediction #4: A new Scottish referendum won’t happen anytime soon
Last year’s Scottish independence referendum generated panic among investors as it became apparent that a ‘yes’ vote was a real possibility, with potentially destabilizing consequences for the UK banking system and economy. But even if the SNP were to hold the balance of power after the next election, it seems unlikely that a new referendum would materialize soon. The party made no mention of another referendum in its manifesto released earlier this month. This should not be surprising – recent polling suggests that the issue ranks extremely low on Scottish voters’ priorities. Even if the SNP wished to reintroduce the question over the next five years, the party’s leverage over a future Labour government may be overestimated (see Prediction #6). A more likely date for the issue to be reintroduced is after the Scottish parliamentary elections in May next year, assuming the SNP holds on to its majority in the Scottish parliament. But it is also worth pointing out that a future referendum would likely be less destabilizing than last year’s events. Precisely because of uncertainty in September, authorities and businesses are now much better informed about the risks of a Scottish exit, particularly with respect to risks concerning the banking sector.
Prediction #5: An EU referendum may be good for the UK economy
Under the Conservatives, a referendum on the UK’s membership in the European Union would likely be held before 2017 following a renegotiation of the UK’s terms of membership. A ‘Brexit’ could have severe consequences for UK growth performance and foreign investment, and the potential impact on business confidence leading into a referendum has been widely noted.6 Less commented on, however, are the potential benefits that a renegotiation could bring to the British economy. As our economists have argued, the UK is uniquely placed to benefit from reforms to the EU Single Market and the Department for Business Innovation and Skills has estimated that the potential gains for British exports could add up to 7% GDP.7 A referendum may be an ideal bargaining chip for the UK to remodel aspects of the EU in its favor. Of course, this would depend on an ‘in’ vote, but polls currently suggest a majority in favor of staying in, particularly after a successful renegotiation.
Prediction #6: A Labour minority government would be more stable than you might think
If no party wins a majority next Thursday, the UK faces the prospect of a coalition or minority government. In the event that SNP support is required to pass legislation in the House of Commons, an increasingly probable outcome given the latest opinion polls in Scotland, the latter seems the more likely option. Labour has ruled out a formal deal with the nationalists. Some have argued that if the SNP held the balance of power, the result could be destabilizing, but the party’s leverage may be less than thought. Even if the SNP found Labour uncooperative on key policy issues, it would not be rational for them to bring down the government with a vote of no-confidence.
This would cause a new election, a possible future Conservative government, and damaging Labour accusations that the SNP had voted down a ‘progressive’ administration (we outline the SNP’s options on a decision tree on the previous page). The party also looks set to perform exceptionally well next week, with some polls suggesting a near clean sweep of Labour’s seats. It is unclear why the party would want to risk these with a new election.
Prediction #7: There may be less change rather than more
Precisely because no party is likely to have enough seats for a majority, it is difficult to envisage sweeping changes to the policy mix. The last five years have seen the deficit cut in half, the employment rate reach a record high and UK growth accelerate above any other advanced economy. Major challenges remain, however. The current account deficit has reached a record, meaning much-vaunted ‘rebalancing’ has failed to occur. Productivity has also been the weakest among any G10 country. This has important implications for wage growth, which has been very slow relative to previous recoveries. Indeed, the current fracturing of the UK’s political environment can indirectly be attributed to imbalances in the labour market. Pollsters find that a key explanatory variable behind support for the UK Independence Party (UKIP), for example, is lack of a university degree. 8 It is unclear whether any major party has the solutions for these issues, but also doubtful that it will have the electoral resources. On the other hand, the doom-laden predictions of certain commentators are unlikely to materialize.
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Finally, Goldman simplifies the decision process to three potential outcomes. While there is a whole range of potential outcomes to the May 7 election, each of the most likely governmental combinations falls into one of three broad groupings:
1. A Conservative-led government (either on its own or in coalition with the LibDems). This is likely to be perceived as the most ‘market-friendly’ outcome, partly because it would come closest to maintaining the status quo and also because the Conservatives’ stated aim is to reduce the budget deficit through cutting current expenditure rather than by raising taxes. Set against this, the Conservatives’ commitment to hold a referendum on EU membership by 2017 and the increased risk of exit would likely be negative for investment spending and UK assets.
2. A Labour-led government (either on its own, with the implicit support of the SNP, or in a formal coalition with the LibDems) would shift the balance of further fiscal adjustment away from spending cuts to tax increases. Labour’s proposals include: raising the top rate of income tax from 45% to 50%; raising the headline corporation tax rate from 20% to 21% (offset by measures designed to help small businesses); increasing the ‘Bank Levy’ on banks’ balance sheets, applying a second ‘one-off’ tax on bank bonuses, removing the non-domicile tax status and introducing a ‘Mansion Tax’ on residential properties worth more than £2 million. At the same time, a government of this complexion would be less likely to contemplate a referendum on Britain’s EU membership.
Of the potential Labour-led government combinations, financial markets would likely respond more favourably to a Labour/LibDem coalition than to a minority Labour government supported by the SNP on a confidence and supply basis. (The Labour party has ruled out a formal coalition with the SNP.) In this scenario, concerns are likely to emerge that reliance on the SNP would pull the Labour government away from the centre to the left of the political spectrum, as well as raising the spectre of distributional policies favouring Scotland at the expense of the UK as a whole.
3. It is also possible that there will be no clear outcome to the election. If no party (or coalition of parties) is able to form a stable government, a second election could be called shortly after the first or a minority government might attempt to struggle on. Again, the lack of clarity surrounding such an impasse would likely be damaging for UK growth and assets.
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The Bottom Line is that at the macro level the implications of the election may be less pronounced than many anticipate. Monetary policy has been de-politicised through the Bank of England’s independence. Moreover, the formation of a coalition government is likely to involve convergence towards centrist positions, while a minority administration that pursues policies outside the mainstream would be unlikely to survive given its fragile parliamentary basis. In either case, the political system is unlikely to deliver radically different macroeconomic outcomes.
Sources: Bloomberg, Goldman Sachs, Societe Generale, and Deutsche Bank