AXA IM's David Page - UK Election 2017: Strong & stable gives way to weak & wobbly
UK General Election 2017 - David Page, Senior Economist at AXA IM: “Strong & stable gives way to weak & wobbly.”
Yesterday’s election defied polls delivering fewer seats to the ruling Conservative government, removing its outright majority. Prime Minister (PM) May is seeking permission to form a minority government, supported by Northern Ireland’s Democratic Unionist Party (DUP). However, this composition is fragile and significant uncertainty surrounds the PM, the Cabinet and for how long this government can continue. This is of particular relevance as the UK is due to start Brexit negotiations with the EU in the coming weeks. The chances of a “chaotic” Brexit appear to have risen. It also questions the direction of domestic policy. This uncertainty likely weighs on economic activity and contributes to our assessment that monetary policy will remain unchanged into 2019. Asset markets have posted some reaction to this change, but ongoing uncertainty and its effects are likely to continue to weigh on sterling over the coming quarters.
The results: another Tory gamble backfires
The outcome of the 8 June snap election defied polling, which had suggested an increased Tory majority. While the Conservatives achieved a larger popular vote (42.4%, compared with Labour 40.2%), they won fewer seats. The Tories (are projected to) have gained 319 seats (down 7 seats), Labour 260 (+29), Scottish National Party 35 seats (-21) and Liberal Democrats (Lib Dems) 12 seats (+4).
A number of trends were in evidence:
- The Labour party did much better than polls suggested with Labour’s share of the popular vote around levels enjoyed under Blair. Turnout was high for UK elections at 68.7% and this appears to have been swelled by a youth (and particularly student) vote that tended to favour Labour.
- The Conservatives made gains in Scotland (+7 seats) and hold more than one seat for the first time since 1997. The charismatic Scottish Tory leader Ruth Davidson no doubt helped this result, but it may also reflect grassroots resistance to another Scotland independence vote.
- The Lib Dem made modest gains but their campaign has been disappointing, with the surprising appeal of Labour preventing greater gains.
The Conservatives are the largest party, but do not hold an outright majority. As we had discussed prior to this election, there are not a great deal of alternatives with this outcome. In 2010, the Conservatives formed a coalition with the Lib Dems. This was unlikely to be repeated given the Lib Dem’s experience of that government (they have still not recovered electorally) and the diametrically different position on Brexit. However, the Conservatives and Northern Ireland’s DUP have often worked together and the Tories are seeking a minority government with support from the DUP. This would create a working majority of 329 seats, greater than the 323 effective majority required (if Sinn Fein follow tradition of not taking up their Westminster seats). This would allow the Conservatives to pass legislation for a Queen’s Speech. But it is far from “strong & stable” government.
Political uncertainty: who governs and for how long?
Who governs? Despite having lost an outright majority, the Tories still look likely to be able to form a government that would be able to hold an effective majority to pass key legislation. With little other obvious combination of parties to deliver a more stable government, this looks like the most likely outcome.
Will May remain Prime Minister? Despite overt questioning from Tory MPs on whether Theresa May would remain as Prime Minister, she has so far stated that she has “no intention” of standing down and is speaking with the Queen over forming a new government. Speculation is likely to continue with Boris Johnson, Michael Fallon, David Davis, Amber Rudd and Philip Hammond all seen as potential contenders. That said, it would be rare for a ‘winning’ government to eject it’s leader and the highly uncertain political environment (and the difficulties it creates for the upcoming Brexit negotiations) may not be best served by changing leaders at this point. Looking ahead, as Brexit negotiations take place there may be limited scope for a leadership change then. However, we think it is likely that if PM May is set to continue, she will be encouraged to change her operating practice and broaden her circle of influence. Insofar as this increases the economic advice she receives, particularly from HM Treasury, we think this will benefit the outlook for the economy and Brexit alike. However, PM May’s position is unequivocally weakened as a result of this election and questions over her Prime Ministership look set to remain.
Cabinet changes? We expect a cabinet to be selected over the coming days. We will particularly look for any changes to the pre-election government. Specifically, we will see if Chancellor Hammond continues in his role (and, if so, if he moves for an additional July budget this year). We will also watch for any shift in key Brexit ministers, including Johnson, Davis and Fox.
Will we see another election before the next scheduled poll in 2022? This will remain a high risk over the coming years. It is unlikely that the Conservatives will rush for another early election: Labour look more electable than before; the prospect of economic slowdown ahead could further weaken Tory support; as could difficult Brexit negotiations. The Fixed Term Parliament Act (FTPA) helps the Tories avoid calling another election. It requires a two-thirds majority for an early poll. Unlike for this election, Conservatives can point to the strictures of Brexit negotiations as a reason not to hold another election. The Tories will also have an eye on the 2018 Electoral Boundary reviews, that should be to their advantage. However, the FTPA also allows for an early election on the back of a vote of “no confidence”, by simple majority. This creates an ongoing risk to the government with such a tenuous hold on power. This will be a particular risk when it comes to the Brexit negotiations, but could also develop over unforeseen domestic issues.
What this means for Brexit
The impact on the upcoming Brexit process is key. A popular view is that this election outcome will lead the government to a “softer” Brexit. In practice, this is difficult. Conservatives and Labour are committed to ending the free movement of people and we see no change in this policy. The EU has been clear that this makes Single Market participation impossible. The Conservatives are also keen to increase trade with the rest of the world and aim to draw up free trade agreements (FTAs) with other countries after Brexit. This is at the heart of their post-Brexit strategy. Although the UK would then seek something close to a Customs Union with the EU, there is no precedent for the EU offering this combination of customs union with external FTAs. To achieve a “softer” Brexit, Tories would have to drop hopes for additional FTAs, which seems unlikely. An additional complication now involves the agreement with the DUP. It is obviously keen to secure an absence of a hard border in Ireland. This is already a priority for the government and the EU. However, the only way for the UK government to guarantee such an outcome would be to remain in the customs union. It is not clear what agreement the Conservatives and DUP will have struck over this.
In all this seems to support EU President Tusk’s observation that the UK’s only real alternatives were “hard Brexit” or “no Brexit”. However, Labour (and others) did campaign on a different (less defined) model for Brexit. This raises the risk that Parliament, which gets to vote on the eventual Brexit deal, could ultimately reject any deal the government makes. This could result in a “no confidence” vote that forces another election.
The difficulty for any government would be that there is no Brexit consensus to deliver: supporters were drawn to Brexit for diverse (and sometimes diametrically opposed) reasons. The problem for this government is that its new fragility increases the difficulty in driving through its version of Brexit, raising the chances of a chaotic Brexit with no deal in place.
And all of that questions the timing of when the negotiations can begin. The EU is prepared to start negotiations in the week commencing 19 June. Assuming the government has its cabinet in place, this should proceed. However, given the degree of uncertainty and prospect for surprise, there is as risk that this is delayed.
Domestic policy direction – which way to turn ?
This also affects the direction of the government’s domestic policy. PM May’s election strategy included a realignment of Tory policy towards the political centre ground. Some in her party will claim that this strategy proved electorally unsuccessful, fuelling calls for a return to more traditional Tory, right-wing policies. At the same time, Labour have proven there appears some appetite for a more interventionist approach.
For now the continuation of a Tory government is likely to be broadly consistent with ongoing conservative management of the public finances (as opposed to a Labour led fiscal stimulus). The Conservative manifesto has increased the government’s flexibility in managing the public finances, which should bolster confidence. There will be some risk that the government chooses to provide some fiscal largesse to key voter groups in the wake of this result. However, latitude to do so should be limited by the impact of expected softer economic growth that will modestly worsen the outlook for the finances.
The economic outlook – uncertainty to slow growth
We have been concerned that the Brexit uncertainty would weigh on the economic outlook. Beyond the likely weakening in household spending, as faster inflation erodes real incomes, Brexit uncertainty looks likely to weigh on investment spending. The outcome of this election only adds to this view. We forecast this to see UK GDP growth slow to 1.7% in 2017 and 1.2% in 2018, with quarterly growth slowing below 0.4% over the coming quarters. Risks to the downside of our forecast have grown.
This is in contrast with the Bank of England, which forecasts growth at 1.9% for this year and 1.7% in 2018. One of the key differences between our views is the assumption of “smooth Brexit”, which the BoE defines as including a deal and transition arrangement. While, on balance, we still hope to arrive at this outcome, we do not think it is something that businesses will be able to take for granted. As such, this is likely to weigh on investment spending.
While BoE Governor Carney guided that if the economy evolved in line with BoE projections policy might have to be tightened more quickly than markets currently considered, we contend that a softer outlook is more likely. As such, we maintain our call that the BoE will leave Bank Rate unchanged into 2019.
We see the heightened political uncertainty, the fragility of the new government and the expected additional headwind on economic activity as likely to have an impact on different asset classes.
Sterling has retraced by nearly 2% against the US dollar and euro. This in part reflects a softening in the UK interest rate outlook. It also likely reflects the increased political uncertainty, with sterling down around 1% after controlling for other economic factors. Both elements appear to have further to run and we look to further downside to sterling, particularly against the US dollar.
Gilt yields (and spreads) rose in the immediate aftermath of the election result, but have subsequently tightened. Gilt yields have to weigh a number of factors. A more accommodative monetary outlook should weigh on yields. However, further sterling weakness and the possibility of a sharper rise in inflation could put upward pressure on break-even inflation. That said, the outlook for gilts is likely to be more determined by the outlook for domestic policy. The government’s increased flexibility to manage the finances should underpin confidence in the gilt markets. However, gilts could remain vulnerable to any shift in government policy if it loosens fiscal policy in response to this election.
The market has remained constructive on GBP credit as the risks of two extreme outcomes (hard Brexit or nationalisations) diminished. With no change in UK corporate fundamentals or market conditions, there is little reason for UK credit risk premia to reprice. However, if political paralysis leads to a severe decline in growth, UK credit would likely widen. GBP credit paper opened a bit wider (1-3bp), before trading back to flat..
The outlook for equity markets is more mixed. The increased uncertainty and adverse headwind for economic growth could weigh on the equity outlook. That said, further sterling weakness is likely to continue to prove supportive for indices, while this outcome has avoided a Labour government which would have included more business unfriendly policies including an increase in the corporate tax rate. This mixed outlook can be seen in the reaction of sterling indices. The FTSE100 traded up over 1.25% on open, but has since settled down to a 0.5% gain, reflecting a mixture of relief (at avoiding a Labour outcome) and sterling support. However, the more domestically focused FTSE250, which benefits less from sterling’s decline, has fluctuated between a fall of 1% and 0.2% and is currently trading 0.6% lower.
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