The Unexpected is Back

The unexpected has again been the outcome of the U.K. election: the Tories have lost their Parliamentary majority, while the Labour Party has substantially increased its position. This result triggers a new period of political instability, with Prime Minister (PM) Theresa May’s position being substantially weakened and increased uncertainty likely to have an impact on Brexit negotiations.

PM May’s objective in calling a snap election was twofold. Firstly, she wanted to strengthen her parliamentary majority in view of the perceived weakness of the Labour party in polls. Secondly, she wanted to avoid having an election in 2020. The Brexit process is scheduled to end in 2019 and having a longer political time horizon after this should help to keep negotiations isolated from domestic political issues. The outcome of this election has resulted in a complete defeat on the first objective and a disappointing result, from the Tories’ point of view, on the second.

Tories have lost the majority of seats in Parliament, while the Labour Party substantially increased its weight: if we look back to the significant divide shown by polls at the beginning of the election campaign, this is a huge failure for PM May. This weakens her position significantly, and at this point, that it is not clear if she will stay, although she has stated that she does not intend to resign. At the moment, it seems likely that she will try to form a government with support from Northern Ireland’s Unionist Parties, but it is not clear if this will achieve a majority position. Of course, this result will inevitably influence the attitude of the government towards Brexit negotiations and could also trigger internal negotiations on national policies.

This political outcome creates further uncertainty about Brexit negotiations. There are a number of open questions, starting from what PM May will decide to do, given the scale of her defeat and what combination of coalition parties will be formed to govern. We expect to find an answer in coming days. What is certain, in our view, is that a hard Brexit (as presented in the Tories’ political manifesto) is now at risk. Moreover, the usual political frictions present in a coalition government will make the formulation of a firm Brexit strategy on the U.K. side even more difficult, which could weaken the U.K.’s negotiating power considerably.

The economic outlook for U.K.

If we consider the economic impact of the Brexit plan so far, we see that in 2016, after the Brexit referendum, the U.K. economy proved to be much more resilient than what anyone would have expected, supported by strong private consumption at the expense of falling saving rates. The most immediate effect of Brexit was a strong depreciation for the Pound Sterling, the effect of which, some months later) was to drive up inflation and squeeze real income, with negative implications for consumption. As a result, despite the improved contribution from net trade, GDP figures were softer in Q1 2017. Overall, U.K. economic indicators have been quite volatile and erratic recently, often providing inconsistent messages. Uncertainty will likely persist until it is clear what level of reorganisation the U.K. economy will need to undertake on the back of Brexit arrangements. However, this is a long-term issue.

According to our forecasts, inflation will peak at the end of 2017 at around 3%, averaging 2.6-2.7% in 2017, and will remain at these levels during 2018. At the same time, GDP is expected to grow 1.8% in 2017 and to slowdown in 2018, a slightly more pessimistic picture than that of the Bank of England, as we see wage growth lagging a bit more.

On the monetary policy side, the Bank of England (BoE) clearly faces a trade-off between the speed at which to stabilize rising inflation and the reduction of the current output gap. We expect monetary policy will remain accommodative, as long as the rise in inflation is sterling-driven and we see the path currently being priced by the market as the most likely. A more aggressive BoE is not likely, since we are a bit less optimistic about growth – even more now given the increased political instability.

The implications for financial markets

We consider what could be the implications of this phase of unsettled political conditions for the sterling, for the U.K. yield curve, and in general for U.K. assets, from a multi-asset perspective.

Given the lack of visibility on the evolution of U.K. economic fundamentals, the Pound Sterling has mainly been trading as a ‘political currency’, driven by news flow and investor expectations regarding the Brexit negotiations. With a weak government and political uncertainty emerging from this election, the path towards a smooth Brexit is less clear. The probability for a “hard Brexit” is now smaller, but the U.K.’s negotiation stance has likely been weakened and medium-term growth prospects for the U.K. could be dampened by the increased uncertainty, with negative implications for the Pound Sterling.

Moreover, in the medium-term, the Brexit decision supposes a number of structural shifts to the U.K. economy, in particular with regard to the weight and role of external factors. Specifically, a substantial loss of FDI (Foreign Direct Investments) could play a prominent role if London shrinks as a financial centre. Since the referendum, this has resulted in a sharp depreciation of the Pound Sterling, but it has recovered some ground as markets started to discount the possibility of a “soft Brexit” and on the back of economic resilience in the U.K. In addition, current levels of Pound Sterling are not particularly attractive from an interest rate differential perspective (U.K. vs U.S.) and we do not expect a more aggressive stance from the BoE.

Regarding the yield curve, we have to take into account Labour’s call for higher taxes, spending and debt issuance, as well as their aim to bring some sectors back under national control. Furthermore, a government with a higher Labour influence would likely have a softer stance on Brexit, with privileged market access being seen as a focal point. A consequence of higher deficits and more debt is higher gilt issuance and a higher risk premium on long-dated rates. Also, increased intervention on the labour market might push up wages, increasing prospects for higher inflation. The BoE, while not immediately reacting, will be very wary of any signs of a sustained shift in inflation expectations and might react if needed. We expect the curve to initially maintain a steepening bias and U.K. rates to underperform on a cross-market basis.

From a Multi-Asset perspective, we consider the inflation linked bond market to be too dear, as it strongly benefits from the demand of local defined benefit pension funds due to current legislation; any change to this could put pressure on linkers. We prefer Japanese and European linkers.

We like European equities in general – without a specific bias to the U.K. market – and we prefer European and Japanese equities to the U.S., as we expect the boost from reflation policies could have more upside in these markets, where valuations are more appealing.

Overall, geopolitical risk could weigh on financial assets, triggering volatility. The recent escalation of terrorist attacks means that voters’ reactions and politicians’ actions are less predictable. We believe potential spikes in volatility can be managed with hedging strategies and assets perceived as safe-haven, such as gold.

About Monica Defend

Monica Defend is the Head of Global Asset Allocation Research with Pioneer. Investments in Italy. She has been working in the investments industry since 1997. She is responsible for providing asset allocation recommendations and core. investment strategies at macro, sector and national level. The Global Asset Allocation Research team is responsible for the short, medium and long-term asset. class forecast; asset class valuation; the construction and implementation of trading rules and closely monitoring the financial markets. Monica moved to the Milan office as Head of Italian Quantitative Research. Prior to that, she was a Quantitative Analyst in the Dublin office. Monica has a degree in Social and Economics Sciences from Bocconi University. She also holds a Master’s degree in Economics from Bocconi University and Master’s degree in Financial Economics from London Business School-Bocconi. She has been a member of the Unicredit Management and Banking Academy since 2004.
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