The election and its implications for the economy and markets - Capital Economics
UK Economics

The election and its implications for the economy and markets

UK Economics Focus
Written by Ruth Gregory

The election on 12th December is likely to mark the beginning of a new phase for the UK economy, determining not only the type of Brexit (or if Brexit happens at all) but also the size and shape of the state. The theme that comes up the most is that after a decade of austerity, the economy will soon benefit from a sizeable fiscal stimulus.

  • The election on 12th December is likely to mark the beginning of a new phase for the UK economy, determining not only the type of Brexit (or if Brexit happens at all) but also the size and shape of the state. The theme that comes up the most is that after a decade of austerity, the economy will soon benefit from a sizeable fiscal stimulus.
  • The worst result for the economy in the near term would be a minority Conservative government or a Conservative coalition as that could prolong the Brexit and policy paralysis. The government may find it hard to get any Brexit deal through Parliament and may not be able to pass a fiscal stimulus. There could be a no deal Brexit on 31st January 2020, or more delays to Brexit that continue to limit economic growth to between 1.0% and 1.5% and result in the pound falling from $1.29 to $1.20.
  • If there were a Labour-led government, either with a majority in Parliament or propped up by other parties, Labour’s opposition to a no deal Brexit would remove a major downside risk and its pledge to raise public investment by around £55bn a year (2.5% of GDP) would provide a big kick to the economy.
  • But Labour’s plan to increase the size of the state to levels not seen since the 1970s so quickly wouldn’t be seamless. And its other policies have an anti-business feel about them. That would dent both business confidence and investment and could keep GDP growth between 1.0% and 1.5%. A Labour win would also probably play badly in the financial markets, leading to slightly higher bond yields, a fall in the pound to around $1.20 and a decline in equity prices of more than 10%.
  • We suspect that the best result for the economy and financial markets in the near term would be a Conservative majority. Passing a Brexit deal by 31st January would remove some of the restraint of Brexit on business investment, the Conservatives plan to implement an extra fiscal stimulus worth £20bn (1% of GDP) and their business-friendly policies would be viewed positively in the financial markets. As it happens, this is also the most likely outcome according to the latest polls. It could result in GDP growth accelerating to between 1.5% and 2.2%.
  • However, that requires the government to quickly strike a trade agreement with the EU or extend the status quo transition period beyond December 2020 soon after passing a Brexit deal. If so, then business investment would rebound significantly and interest rates would probably rise late in 2020. But if businesses fear that a trade agreement won’t be reached in time, which would then lead to something similar to a no deal on 31st December, then investment would probably be kept on ice, GDP growth would stay between 1.0% and 1.5% and interest rates wouldn’t rise until 2021.
  • Overall, as long as the election doesn’t deliver more policy paralysis in the form of a Conservative minority government, then over the next few years the economy would probably benefit from a further fiscal stimulus and a resolution to Brexit one way or another. But that improvement could be restrained if the Conservatives win but refuse to extend the transition period or if Labour wins and puts in place its anti-business polices. So while there is potential for the economy to perform much better over the next few years, the clear risk is that politicians continue to hold it back.

The election and its implications for the economy and markets

Without a doubt, the 12th December election marks a major turning point for the economy. We took an initial look at the possible influence of the election on the economy back in October (see our UK Economics Update “How will the election influence the economy?” 29th October 2019) and have since addressed various election issues in a series of short Updates. (See Table 6 for a full list.) This Focus brings everything together and incorporates the policies of the main party manifestos.

Who will win?

With just 16 days to go until the election, the latest opinion polls show the Tories have a 12 point lead over Labour. (See Chart 1.)

Chart 1: General Election Voting Intentions (%)

Source: Various polls

As things stand, the Conservatives are expected to win 359 seats, a majority of 33. By comparison, Labour are expected to win 208 seats, the Scottish Nationalists (SNP) 41 seats and the Lib Dems just 20 seats. Based on this, Electoral Calculus puts the chances of a Tory majority at 74%. (See Chart 2.)

Chart 2: Chances of Election Outcomes, 25th Nov. (%)

Sources: Electoral Calculus , Capital Economics

Of course, things can change quickly. At the same point of the 2017 election campaign, Theresa May held a similarly large lead, but she had lost most of it by election day. And crucially, the Labour Party doesn’t necessarily need an outright majority to take power – it just needs to prevent the Conservatives from getting one. That’s because it has more chance of ruling in a coalition with the SNP and the Lib Dems, in which the parties would unite around holding a second referendum on Brexit. So instead of a 22% swing in the polls, the party only needs a 7% swing in order to stop the Tories from winning a majority. (See Chart 3.)

Chart 3: Swing Against Gov’t Needed by Labour (%)

Sources: Electoral Calculus, Capital Economics.

In what follows, we consider the implications for the economy and the financial markets of three election outcomes; a Conservative majority, a Conservative minority and a Labour-led government, in which either the Labour Party has a majority or governs with a minority supported by other parties. We consider Brexit and the parties’ other policies and then the influence of both together.

Brexit

The channel through which the election will have the biggest impact on the economy is clearly via the effect on the path to, and final form of, Brexit.

A large Conservative majority: This would probably lead to Boris Johnson’s Brexit deal passing in late December or in January. But the Conservative’s manifesto pledge to strike a trade agreement by December 2020 and not to extend the status-quo transition period would keep alive the possibility of something like a no deal Brexit at the end of 2020. If there is a risk of such an event, business investment may not accelerate much next year, even after a Brexit deal. (See our UK Economics Update, “Johnson’s Brexit deal could allow uncertainty to linger”, 24th October.)

A minority Conservative government or Conservative coalition: This would make it harder for the Prime Minister to pass his Brexit deal and make it easier for other parties to disrupt proceedings, leading to further Brexit delays. And the PM could be more beholden to the Brexit hardliners. So not only would there be a chance of a no deal Brexit on 31st December 2020, but there would probably be a lingering chance of a no deal on 31st January too.

A Labour-led government: A Labour victory would almost certainly lead to another delay to Brexit beyond 31st January, as Labour seeks to negotiate a softer Brexit deal and put it to a second referendum within six months, with “remain” as the other option. Presumably any coalition or supporting parties would get on board with this timetable. Ultimately, a Labour victory would rule out a no deal Brexit at any point and a second referendum could lead to a softer Brexit deal or the UK remaining in the EU.

Table 1 summarises how these election outcomes could influence Brexit, with the most favourable outcomes for the economy in the near term at the top and the least favourable at the bottom. It shows that the best outcome for Brexit is a Labour-led government, the worst is a Conservative minority government and a Conservative majority is somewhere in between.

Table 1: Implications of Election for Brexit Outcomes

Large Conservative Majority

Conservative Minority

or coalition

Labour-led gov’t

“Good” outcomes

Remain

X

X

Brexit deal

X

Further delays

X

No deal 31st Jan.

X

X

No deal Dec. 2020

X

“Bad” outcomes

Source: Capital Economics

Taken together, and based on the recent polling, we calculate that there is currently something like a 55% chance of a Brexit deal on 31st January, a 20% chance of a no deal on 31st January, a 20% chance of a delay beyond 31st January and a 5% chance of remain. We wouldn’t recommend placing much weight on these exact numbers. Instead, our downloadable “Brexit & Election Simulator” allows clients to generate their own Brexit probabilities based on their own sense of how the election will play out.

Other policies

Of course, the election is not just about Brexit and the parties’ other plans have dominated the headlines. There are substantial differences in three areas; the amount of fiscal stimulus, the projected size of the state and the shape of the policies. (Table 5 sets out the major proposals.)

The future fiscal stimulus

Both parties have pledged to increase spending in 2020/21 as announced in September’s Spending Round, so a £13.4bn (or 0.6% of GDP) fiscal boost is already baked into the cake. Their additional plans are broadly neutral for the “current” budget as the planned increases in day-to-day spending are fully funded by their plans to raise tax revenues. The Conservatives aim to raise the level of both spending and tax revenues by around £3bn by 2023/24, while Labour plans to raise them by £83bn. (More on this later.)

The main divergence when it comes to the future fiscal stimulus stems from investment spending. While the Conservative Party manifesto shows that only £8.1bn of extra investment spending has been allocated by 2023/24, it notes that there is room under their new fiscal rules for investment spending of £100bn over the next five years, or about £20bn a year. If the Conservatives win the election, we assume they will use all of that room.

By contrast, Labour has pledged to raise investment spending by £400bn. That’s made up of £250bn over ten years in a “Green Transformation Fund” (£25bn a year) and £150bn over five years in a “Social Transformation Fund” (£30bn a year). Assuming this spending is evenly spread, the plans suggest that investment spending would be £220bn higher in 2023/24, an increase of £55bn a year (or 2.6% of GDP).

That would more than double government investment from £46.8bn now (2% of GDP) to over £100bn (4% of GDP) and leave it at levels seen in the 1970s, when the government was last investing in nationalised industries. (See Chart 4.)

Chart 4: Public Sector Net Investment (As a % of GDP)

Sources: OBR, Labour, Conservatives, Capital Economics

So if both parties followed the plans outlined in their manifestos, the Conservatives would raise borrowing by around £19bn a year and Labour would increase it by £55bn, a difference of £36bn (1.7% of GDP). (See Table 2.)

Table 2: Manifesto Fiscal Pledges

(£bn, by 2023/24)

Conservatives

Labour

Current spending, of which:

Day-to-day spending

+2.9

+82.9

Tax Revenues

+3.7

+82.9

Cost / (Saving)

(0.8)

0.0

Investment:

Allocation in manifesto by 23/24

+8.1

Intention per year

+20.0

+55.0

Borrowing implied by manifesto

+19.2

+55.0

(+0.9% of GDP)

(+2.6% of GDP)

Sources: Conservatives, Labour, Capital Economics

The size of the state

On top of that, both parties have very different visions for the size of the state. The Conservatives announced in September’s 2019 Spending Round their plan to increase day-to-day spending by £11.7bn in 2020/21. Their manifesto pledges to raise spending by only £3bn more by 2023/24 and tax revenues by a similar amount are tiny compared with Labour’s plans to increase both by an extra £83bn.

So while the blue lines show that the plans of the Conservatives don’t alter the status quo much, the red lines show that Labour’s plans would increase tax revenues as a share of GDP to the peaks in the 1970s and 1980s and raise the share of spending from 38% of GDP to around 45%, its highest (barring the financial crisis) since the mid-1970s. (See Chart 5.)

Chart 5: Government Revenues (As a % of GDP)

Sources: Labour, Conservatives, Capital Economics

Admittedly, there is no convincing evidence that suggests a bigger state sector is better or worse for an economy. The black diamonds show that some countries that have a relatively large state have relatively high per capita GDP growth (Norway and Sweden) while some countries that have a relatively small state have high growth (the US). (See Chart 6.) But even if it were achievable, changing the structure of the economy so significantly, so quickly is unlikely to be seamless.

Chart 6: Government Spending (As a share of GDP, 2018)

Source: Resolution Foundation

What’s more, this increase in the state excludes Labour’s plan to nationalise parts of the rail, energy, water, post and telecommunications sectors. Labour’s manifesto suggested that as this would involve the equity of shareholders being swapped for gilts, the fiscal impact would be neutral. That may be true, but it would further increase the size of the public sector and the influence on the economy may not be neutral. After all, nationalised industries tend to be less efficient than private companies. And Labour has suggested it would not compensate shareholders at market value.

The shape of the policies

There are also sizeable differences between the shape of the policies. The Conservatives plan to cut taxes for individuals by raising the National Insurance threshold from £8,632 to £9,500 in April 2020, which is largely funded by the scrapping of the planned cut to corporation tax from 19% to 17% in April 2020. But by and large, the party’s non-Brexit policies retain their business-friendly feel.

In contrast, Labour intends to fund its extra spending on health and education partly by raising taxes for high-income earners, but mostly by hiking taxes for businesses. For example, £38bn of the £83bn proposed rise in taxes comes from businesses, particularly the proposed increase in the corporate tax rate from 19% to 26%. (See Chart 7.) So Labour’s policies have an anti-business feel about them.

Chart 7: Manifesto Commitments (£bn, Annual in 2023/24)

Sources: Labour, Conservatives, Capital Economics

At the same time, Labour’s plan for 10% of shares in all large businesses to be transferred to employees creates another uncertainty for businesses. And while Labour’s plan to boost social homebuilding by 150,000 a year could provide an extra kick to economic growth, we don’t think it is achievable. (See our UK Housing UpdateAre social homebuilding plans realistic?” 22nd November.)

The OBR’s fiscal multipliers suggest that if the Conservatives increased spending by the full £20bn a year it could boost GDP by up to 0.9% while Labour’s plans point to a boost of up to 2.5%.

In theory, the big increase in investment spending in Labour’s plans could provide a permanent boost to GDP growth if it were to support the long-run potential growth rate of the economy. But in practice some of the boost would probably be offset by the negative effects of Labour’s anti-business policies. That could hinder GDP growth in the near term, which was certainly the lesson from the election of a left-wing government in New Zealand in 2017. (See our UK Economics UpdateLessons for the UK from New Zealand’s Labour government”, 18th Nov.)

In any case, Labour has not addressed the big question of how the huge boost will be achieved. To be fully effective, investment would need to be in worthwhile projects. And this might be difficult given that government investment would be at the highest share of GDP since the 1970s. And in reality, Labour’s policies could be deterred by the risk of an adverse market reaction, a potential coalition partner or simply because they get bogged down in Brexit.

Whoever wins the election, the most likely result is that the economy will benefit from a fiscal stimulus. That stimulus would probably be larger if there were a Labour majority rather than a Conservative majority, but a Labour majority would come alongside other less favourable changes to the size and shape of the state. Meanwhile, the stimulus would be smaller and other policies more limited if there were a Labour minority/coalition.

What would be the impact on the economy?

Bringing all of this together, there is a clear trade-off for the economy between the stance on Brexit and other policies. Put simply, the economy may have to cope with either a hardish Brexit under a Conservative government with business friendly policies, or a softish Brexit or no Brexit at all under a Labour government with policies that would squeeze businesses profits.

Table 3 illustrates this. The top row summaries the results from Table 1 earlier and shows that when it comes to Brexit, the most favourable outcome is a Labour-led government and the least favourable is a Conservative minority or coalition. The second row shows that the Conservative’s business-friendly policies are more favourable, while Labour’s business-unfriendly policies are not. The third row adds up the two rows above it. It suggests that the best overall result for the economy is if the Conservatives win with a majority, the worst is a Conservative minority government.

Table 3: Influences of Brexit & Policies on the Economy

Large Conservative Majority

Conservative Minority or Coalition

Labour-led gov’t

Brexit

2

3

1

Policy

1

2

3

Sum

3

5

4

Source: Capital Economics. *1 is the most favourable, 5 is the least.

For some time, we have been publishing three scenarios for the economy based on the most important Brexit outcomes (deal by 31st January, no deal on 31st January and many more delays). (See Chart 8.) Note that in the near term at least, a decision to “remain” is similar to our deal scenario.

Chart 8: GDP in Different Brexit Scenarios (%)

Sources: Refinitiv, Capital Economics

A Conservative majority would be similar to our deal scenario, which already includes an extra fiscal stimulus worth £20bn (1% of GDP), but with the downside risk of a smaller rebound in business investment if the threat of something like a no deal in December 2020 lingers. A Labour-led government would be similar to our repeated delays scenario as Brexit would be delayed again and due to the effects of some of its other policies, but with some upside risk from the elimination of the risk of a no deal and the possibility of a fiscal stimulus. A Conservative minority would also be similar to a repeated delays scenario, but with downside risks caused by the possibility of a no deal Brexit on either 31st January or something similar at the end of December 2020.

Monetary policy

With the fiscal debate dominating the build up to the election, comparatively little attention has focused on the future behaviour of monetary policy.

None of the parties look likely to revolutionise the monetary policy framework like Labour did in 1997. However, it would be no great surprise if the regime was subject to some alteration in the next parliament, perhaps to allow the Monetary Policy Committee (MPC) to take greater account of asset prices and credit growth, as Labour has hinted at in the past – although note that it was not mentioned in Labour’s 2019 manifesto.

Whatever changes are made to the monetary policy framework, however, the dominant influence on monetary policy after the election will continue to be the general state of the economy. In theory, the bigger the post-election loosening in fiscal policy, the greater the need for offsetting tightening in monetary policy. As such, Labour’s ambitions to increase government spending by more than the Conservatives might suggest that monetary policy would be tighter under Labour.

But we suspect that the MPC would be reluctant to tighten policy – or keep it much tighter than otherwise – given that Labour’s other policies could significantly dent business confidence and investment. That is why if Labour won, after falling from 0.75% to 0.50% in early 2020 as Brexit is delayed, we think that interest rates would only rise to 0.75% in 2021.

We suspect that if there were a minority Conservative government then the MPC would cut rates in the near term too. However, if a Conservative majority led to a Brexit deal by 31st January, a reduction in Brexit uncertainty and a large fiscal stimulus would probably trigger rate hikes from late 2020. Under the Conservatives, then, we think that there is scope for interest rates to rise the most, perhaps reaching 1.50% by the end of 2021. (See Chart 9.) However, if the transition period is not quickly extended beyond December 2020, then rate hikes could be postponed until 2021.

Chart 9: Bank Rate (%)

Sources: Bloomberg, Capital Economics

The markets

A decisive Conservative win could trigger a “relief rally” in sterling, from $1.29 now to around $1.35, and the stock market. But since markets have now largely priced in a Tory victory, such an outcome may not have a big market impact. And the rally may not be sustained either. After all, the markets’ focus could quickly switch from relief over a Brexit deal in January 2020, to concerns over something similar to a no deal in December 2020.

Conversely, a narrow Conservative victory would probably lead to a fall back in gilt yields and a drop in the pound to around $1.20, given the increased influence of Eurosceptics in the party and the higher chances of a no deal Brexit.

There are no obvious signs that financial markets are beginning to panic about the prospect of a Labour government. However, that is probably because of the expectation that Labour will not win the election.

We continue to think that a Labour win would play badly in financial markets. Increasing the corporate tax rate from 19% to 26%, for example, would reduce post-tax earnings per share for the FTSE 100 by about 9%. And Labour’s proposed “included ownership funds” would require large companies to give a 10% equity stake to employees. If this were achieved by issuing new shares that dilute existing owners, this implies a 10% loss to them. Specific industries, such as the financial, oil and gas and utility sectors would be hit hard by higher taxes and nationalisation. (See Global Markets Update “UK shareholders should worry about a Labour win”, 22nd November 2019.)

We think that the pound would fall from $1.28 now to about $1.20, as Labour’s anti-business policies outweigh the positives of a softer Brexit stance. (See UK Economics Update “Would a Labour victory be a loss for the pound?”, 22nd November 2019.) (See Chart 10.)

At least with interest rates remaining low and little risk of debt sustainability becoming a concern, we don’t think a Labour win would be a bloodbath for gilts. In the grand scheme of things, the 10-year yield of 1.25% that we forecast by the end of 2021 would still be fairly low. (See UK Economics Update, “Would investors shun gilts if Labour won the election?” 20th November 2019.)

Chart 10: $/£

Sources: Refinitv, Capital Economics

Overall, though, if the election delivers an unexpected Labour win, there is plenty of scope for equities and sterling to fall.

Conclusion

Rarely have voters been asked to pass judgement at such a critical time for the economy and for financial markets. The 2019 election is likely to mark the beginning of a new phase for the UK economy, determining not only the type of Brexit (or if Brexit happens at all) but also the size of the state.

Table 4 provides a summary of how we think the economy and the financial markets would perform in four election scenarios, this time highlighting the difference between a Labour majority and a Labour minority government.

The best result for the economy and financial markets also happens to be the most likely, namely a Conservative majority and a big fiscal stimulus. However, if the Conservatives do not quickly extend the transition period then Brexit uncertainty could persist for longer, weighing on business investment and overall growth. The worst result for the economy would be a minority Conservative government or a Conservative coalition in which there isn’t a fiscal stimulus, uncertainty lingers, and there is still a chance of a no deal Brexit on either 31st January or on 31st December.

A Labour-led government probably lies somewhere in between for the economy. While Labour’s policies to pursue a soft Brexit or no Brexit and implement a big fiscal boost would be positive for the economy, its anti-business policies could damage business confidence and investment. However, this would probably be the worst outcome for the financial markets.

Table 4: Implication of Various Election Outcomes for the Economy and the Financial Markets

Source: Capital Economics

Table 5: Main Fiscal Policy Proposals

Sources: Party Manifestos, Capital Economics

Table 6: Previous Research on the General Election

Date

Publication

Title

18th April 2018

UK Economics Focus

Should we fear a Labour government?

4th June 2019

UK Housing Market Update

Would Labour’s policy proposals make a difference?

11th July 2019

UK Economics Focus

Political risks and three big economic trends

4th September 2019

UK Economics Update

Key points on the next general election

28th October 2019

UK Economics Update

Parliament votes on general election

29th October 2019

UK Economics Update

How will the election influence the economy?

6th November 2019

UK Economics Chart Book

Economy could hit the government’s lead in the polls

7th November 2019

Capital Daily

Looser fiscal policy unlikely to mean a bloodbath for gilts

7th November 2019

UK Economics Update

New fiscal rules clear the way for pre-election splurge

11th November 2019

UK Economics Update

A Conservative election win could boost UK equities

13th November 2019

UK Markets Outlook

Upside risks of the election outweigh downside risks

18th November 2019

UK Economics Update

Lessons for the UK from New Zealand’s Labour gov’t

20th November 2019

Capital Daily

UK election campaign could be the calm before the storm

20th November 2019

UK Economics Update

Would investors shun gilts if Labour won the election?

22nd November 2019

UK Housing Market Update

Election 2019: are social housebuilding plans realistic?

22nd November 2019

Global Markets Update

UK shareholders should worry about a Labour win

22nd November 2019

UK Economics Weekly

Labour’s big plans for the state

22nd November 2019

UK Economics Update

Would a Labour victory be a loss for the pound?

Source: Capital Economics


Paul Dales, Chief UK Economist, +44 20 7808 4992, paul.dales@capitaleconomics.com
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com
Thomas Pugh, UK Economist, +44 20 7808 4693, thomas.pugh@capitaleconomics.com
Andrew Wishart, UK Economist, +44 20 7808 4062, andrew.wishart@capitaleconomics.com
William Ellis, Research Economist, +44 20 7808 4068, william.ellis@capitaleconomics.com