One year after the Brexit referendum and two years after the Scottish independence referendum, U.K. voters have surprised the country and the markets once again, with a dramatically different election outcome than suggested by almost every poll: Instead of an enlarged Conservative Party majority, which Prime Minister (PM) Theresa May wanted to see, the result of the June 8 general election is a “hung parliament” – no party controls a majority.
Thus, the election implies uncertainty and profound challenges for governing the U.K. in general and negotiating Brexit with the European Union (EU) in particular – and by extension for U.K. macro and market performance. That said, Invesco Fixed Income believes this latest political shock is more of an idiosyncratic story for the sterling currency and U.K. government bonds (gilts) than the sudden, but ultimately transitory, global financial shock triggered by the Brexit referendum a year ago.
Over the longer term, however, we believe the U.K. may offer a major opportunity for global fixed income investors to offset the general macro trends in the rest of developed markets, after the current uncertainty. The immediate future holds political instability and probable downside pressure on already weakening U.K. growth due to increased uncertainty regarding the governance of the U.K. in general and managing Brexit in particular.
In the short term, these challenges are likely to keep sterling weak and gilt yields low, in our view. Stepping back and taking a birds-eye view, however, we believe that the longer-term outlook holds significant upside potential for sterling and gilt yields.
Younger voters turn out in force
The U.K. general election surprise owes to much greater participation and activism by younger voters than in prior elections or the Brexit referendum, as well as a surge in voter turnout. The risk of U.K. fragmentation has also receded: The shift away from the Scottish National Party suggests that support for Scottish independence has fallen further since the 2014 independence referendum – despite First Minister Nicola Sturgeon’s efforts to politically link Scottish independence and continued EU membership.
We, therefore, believe that the election will, in effect, push the U.K. toward the centre rather than the extremes of populism and nationalism that gained ascendancy during the Brexit referendum campaign. As a result, Brexit will probably be softened, possibly delayed or perhaps even prevented entirely.
We believe this to be the central scenario, despite Prime Minister May’s signals that there will be no change in her Brexit stance despite the election outcome. Even though PM May and Brexit Minister David Davis, among other senior Conservatives, equated the snap election with a referendum on the Conservative preference for a hard Brexit (a complete exit from the EU), PM May is very likely signalling no change in her Brexit stance for both domestic and European political reasons:
- To hold the Conservative Party together in the face of the underlying split between hard and soft Brexiteers, given the confidence vote that lies immediately ahead.
- To signal that she will aim to strike a hard bargain and to emerge from the election and confidence vote with an unchanged Brexit agenda rather than shifting with the political winds.
While our central view of a soft Brexit (a partial exit from the EU) has been reinforced by this election surprise, we also acknowledge that a downside risk has also increased. The Brexit clock is ticking – time will run out in March 2019, so the threat of a disruptive crash out of the EU with no deal has risen because domestic political instability may retard progress. The U.K. might hit a pause button on the Brexit process, but this would require EU approval and might also face strong resistance within the Conservative Party, especially from hard Brexiteers.
Prime Minister May seeks to form a minority party government
The options going forward are a coalition in which different parties govern jointly, or a minority party government, which the leader of the largest party would form, subject to a parliamentary vote of confidence. PM May is now seeking to form a minority government with the support of the Northern Ireland Democratic Unionist Party (DUP). This falls short of a formal coalition and, instead would likely run on an issue-by-issue basis.
The U.K. has had both coalition and minority governments in the past that have served out full parliamentary terms, even with decent legislative results. However, the U.K. has not formed “grand coalitions” of many parties in the style of Germany, for example; this lack of precedent very likely rules out an alternative coalition of the other small parties centred on the Labour Party.
If Brexit happens, it will need to be softer
The politicking around the formation of a new government is fluid and ongoing. Nevertheless we can discern the political contours of a jerry-rigged, unstable government that will push the U.K. toward a softer version of Brexit than the clean break involving exit from the single market and customs union that PM May continues to signal.
This backdrop of conditional support for a minority government suggests that PM May will have to negotiate issue by issue rather than be able to rely on a general level of support from her own party and a coalition partner. The Brexit talks are currently scheduled to begin on June 19, and PM May could well aim to go ahead as quickly as she can, for both she personally, and the Conservative Party, will benefit from momentum in the negotiation process to shift parliamentary, press and popular focus from domestic politics to Brexit.
Will May survive the summer?
It will almost certainly be much more challenging to run a minority or coalition government now. Prime ministers who have presided over the loss of parliamentary control often faced leadership challenges or early elections. For the time being, senior Conservative Party members are backing PM May – not least because they fear that another, immediate Conservative Party succession struggle, like the one that followed the Brexit referendum, could result in further instability and another early election – in which Labour could gain even more seats. We therefore expect the Conservative Party to be more compromising on Brexit in order to retain support, rather than risk losing power in another election that might itself become a new Brexit election with an outright Tory loss.
The impact on the economy and economic policy
The U.K. economy has already shown signs of slowing consumer demand as real incomes have been squeezed by the fall of sterling and rising import prices. This process is likely to be deepened by the political shock, but there are some potential offsets.
First and foremost, we believe the Bank of England is now even less likely to remove quantitative easing and accommodative monetary policy than before. This would help keep sterling weak, in turn supporting tourism and exports, which have helped cushion the short-term fallout of Brexit for some time.
The election is most directly read as a rejection of the Conservatives’ hard Brexit strategy, and perhaps secondarily as a rejection of fiscal austerity. There is some room – about 1% of gross domestic product – for fiscal expansion in the current budget, which the government might look to use. Signals about budgetary policy will be even more closely watched in the markets than usual.
Furthermore, if firms and households sense that the position on Brexit is softening or being delayed, it may generate greater confidence about the long-run outlook by reducing the fear of a hard Brexit or of a disruptive exit with no deal. This, in turn, might help boost investment and consumption.
Our economic outlook thus ties in with our political outlook directly – we believe the U.K. is likely to suffer further uncertainty in the short term, keeping sterling weak and gilt yields low; yet over time, sterling may be well-placed to stage a significant recovery as a softer, more delayed Brexit unfolds, leading to potentially better economic performance and higher bond yields.