The Outcome of the U.K. Election
Have you ever wondered what Game of Thrones would look like if it came from the writers of Monty Python? Wonder no more. For the second time in less than a year a UK Prime Minister has gambled with their political future and lost. Last June, PM David Cameron inadvertently set his country on a path to exit the European Union (the so-called Brexit). Last week, in a move that would make Cersei Lannister proud, Prime Minister Theresa May reached for the green wildfire—and it blew up in her face.
With formal Brexit negotiations scheduled to begin in mid-June, May back in April called for a snap general election in an attempt to consolidate her party’s power. Polls at that time indicated her conservative Tory party might pick up double-digit seats in the UK parliament, strengthening her ability to negotiate Brexit on her own terms. However, after a short campaign filled with missteps, the UK electorate revolted against May’s plan for a relatively clean break from the European Union (EU). Instead of adding to her 331-seat majority, the Conservative Party was handed a stunning loss, giving back 12 seats which leaves them with 319—below the 326 required for a majority government.
As of last week, May was seeking to stay in power by forming a coalition government with the pro-Brexit Democratic Union Party (DUP) from Northern Ireland. (The voting block of the 319 Conservative members of Parliament, along with the DUP’s 10 seats, would give the coalition more than the 326 for a majority). While May will remain prime minister for now, she has been severely weakened and no one can say for sure how long she can last. As the UK political environment has become more unstable, one thing has become more clear: The weak hand that the UK had to play going into Brexit negotiations has become even weaker.
So far the investment reaction has been fairly muted. Great British Pound (GBP) is down just over 1%, which conversely has bolstered UK stocks to the tune of about +0.5% as measured by the FTSE 100 Index (market performance as of 6/9/17). UK 10-year bond yields are lower by less than 2 bps—hardly a sign that markets are cracking or the British economy is in trouble. This relatively modest reaction reflects the reality that little in the big picture has changed. Brexit is still on, May is still the PM (at least for now), the Bank of England remains accommodative, and weak sterling is still supportive of UK risk assets. We continue to believe that most of the damage from Brexit will be released through the currency channel in the form of weaker GBP. However, with GBP already down 13% against both the US dollar and euro since the Brexit referendum, much, but not all, of the pain has already been priced in.
What’s Next for Brexit?
The path of Brexit was highly uncertain even before yesterday’s election. From the beginning, bargaining positions on both sides seemed somewhat entrenched. May reaffirmed this idea on several occasions noting that “no deal” was better than a “bad deal.” On the other side, in seeking further integration and strengthening of the union, the EU can’t afford to set the precedent of a preferential withdrawal. Adding fuel to the fire, the Europeans then upped the ante by claiming a €60–100 billion “Brexit bill” for commitments made by the UK while under the EU. While formal negotiations had yet to begin, little in the way of compromise could be seen on the horizon. While it’s too early to tell, May’s rebuff certainly weakens the UK hand going forward.
From a macro standpoint, much of initial economic concern has been focused on maintaining free access to each other’s trading markets instead of reverting to the tariff system of the World Trade Organization (WTO rules). However, GBP’s weakness has ameliorated some of these fears. For UK businesses, trade competitiveness may not be the biggest problem. The uncertain post-Brexit status of EU and UK citizens working across the continent creates perhaps an even more pressing problem: Will businesses still have access to enough workers with the right skills? This may be the larger long run threat to the EU and UK economies.
For investors, the market’s underwhelming reaction is becoming something of trend. China’s partial devaluation of RMB in the summer of 2015 resulted in a six-week swoon for global assets. The pain from last June’s Brexit vote lasted two days before markets fully recovered and continued their rally. Markets faltered for two hours on Trump’s election, from about 8pm to 10pm ET, until it became clear that Republicans would sweep both houses of Congress—driving the S&P 500 up 14% in the next six months. Finally, the much-anticipated Italian Referendum in December came and went without so much as a blip in the capital markets. It appears that investors are developing an immunity to political events, a healthy skepticism for the short-term noise that may drive prices but doesn’t change the underlying fundamental strength of the global economy today.