UK election: Political risks rising

The UK has long prided itself on the stability afforded by its two-party political system. This had, on the whole, produced stable administrations able to govern without the need for coalitions or the support of other parties. The 2010 election saw that all change, with the current Conservative-Liberal Democrat government the first coalition since the war. And British politics has subsequently fragmented even further, notably as a result of the rise of the Scottish National Party (SNP), making the identity of the government that will emerge from the election on 7 May more uncertain than for any election since before the war.

The two main parties are running broadly neck and neck in the polls (for daily updated poll forecasts see here or here), as they have been for the entire campaign, with both predicted to fall well shy of the 322 seats required to win a confidence vote. And with the Lib Dems expected to perform particularly poorly, if the projections are correct the current coalition would not have sufficient seats to govern. Whichever of the two main parties comes out on top on Election Day, they look bound to require the support of at least one other party to form a government.

UK: Number of seats held by party*UK_number of seats held by party - 24Apr15

*Dotted line represents the number of seats required for a majority. Source: ElectionForecast and Daiwa Capital Markets Europe Ltd.

Polls of course can be wrong. And the one hope for the Conservatives is that, as in 1992, there are a large number of people too embarrassed to admit to pollsters their true intention to vote for them. But opinion polls now adjust for this factor and it would require the polls to be underestimating the Conservative vote by more than 4ppts for a repetition of 1992.

So, come 8 May, the chances are that the UK will be faced with the prospect of a protracted period of uncertainty about what the next government will look like. And the negotiations over forming a government are likely to last much longer than the five days seen after the last election given that there is much less prospect of a formal coalition – the more likely outcome is a more informal agreement for smaller parties to provide support on important votes (for an explanation of the process see here). And, of course, the longer that uncertainty persists, the greater the risk that UK financial markets get jittery.

But, provided agreement can be hammered out, the most likely arrangement capable of governing looks currently to be a Labour-led administration supported by the SNP, possibly the Lib Dems (and perhaps other small parties). If the Conservative Party does get as few votes as predicted, there will be no plausible way for it to garner sufficient support to win a confidence vote, even with the backing of the Lib Dems and Unionists in Northern Ireland. So what would that mean for policy? And what are the implications for markets?

UK: 2015 election poll tracker*

UK_2015 election poll tracker - 24Apr15

*Average of surveys on each day. Source: Various polling organisations and Daiwa Capital Markets Europe Ltd.

For a start, both the Conservatives and Labour are committed to further deficit reduction. The Conservatives are targeting a balanced government budget by the end of the next Parliament. The Labour Party’s plans, on the other hand, envisage only the elimination of the current budget deficit – the government would still be borrowing to fund investment. This is an arguably more economically-coherent fiscal policy framework, but is one that does imply higher levels of government borrowing. To put the differences into perspective, the independent Institute for Fiscal Studies has calculated that, under Conservative plans, the government debt-to-GDP ratio would fall from the current 80% of GDP to 72% by 2019-20. Under Labour plans, that ratio would stand at 79% of GDP.  This is a difference in debt stock that is fairly large in nominal terms (about £90bn) but will not have a material impact on perceptions of the UK’s creditworthiness. However, with the forecast for net borrowing under Labour more than ½ppt of GDP higher next year and more than 1½ppt higher in 2016-7 than under the Conservatives, Gilt yields may be slightly higher, not least because GDP growth should be firmer and the outlook for monetary policy somewhat tighter.

How deficit reduction is to be achieved also differs between the two main parties. The Labour Party is targeting higher taxes, particularly on the rich with, among other things, the reintroduction of the 50% top rate of tax, the abolition of the anachronistic “non-dom” tax status and the introduction of a “mansion tax” on properties worth over £2mn. The Conservatives, on the other hand, see deficit reduction coming predominantly via spending cuts. But both parties’ plans are far from watertight – the assumed take from the planned tax increases and anti-avoidance measures in the Labour plans are, at best, optimistic, while the required spending cuts in the Conservative plans seem implausible given the commitment to protect a large proportion of government spending from cuts, and the additional spending promises they have made during the campaign. But notwithstanding the rather optimistic nature of both parties’ fiscal plans, there is nothing in either of them, if implemented broadly as set out, to significantly upset a Gilt market that has shrugged off repeated missed deficit reduction targets over the past five years.

Indeed, from a medium-term perspective, a Labour-led government may well provide less volatility for UK financial markets than a Conservative one would, if David Cameron made good on the party’s commitment to hold an “in/out” referendum on EU membership by the end of 2017. This referendum, which would supposedly follow the negotiation of an amended EU Treaty (something no other major EU country wants to see happen), would have the potential to trigger significant financial-market instability given the potentially immense consequences for the UK economy of EU exit. Certainly such a vote, if held tomorrow, would be too close to call and, like last year’s Scottish referendum, would likely see only a narrow verdict one way or the other, leaving open the prospect of another referendum in the not too-distant future.  

If a stable government arrangement can be put in place (a big ask admittedly given the likely fractured nature of the House of Commons post-election and the fact that the SNP’s infrastructure at Westminster may struggle to control so many new MPs), some near-term financial market volatility in the shape of weaker sterling, equities and Gilts might be expected under a Labour-led government. But the medium-term consequences for both the economy and markets are likely to be relatively modest. Nevertheless, the post-election landscape looks to be one where political risks are elevated – a minority government based on a loose “confidence and supply” arrangement with nationalists would be inherently more unstable than a formal coalition, while the consequences of an EU referendum in the event of a Conservative-led government could be profound. So, for investors, keeping an eye on UK political developments is likely to remain of greater importance than it has for decades.

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