As the markets have priced in a high chance of this Thursday’s election delivering a Conservative majority there is little immediate upside left for the pound or gilt yields, although equities might still get a boost. There is, however, lots of scope for a negative market reaction if there is a different election outcome. In that case, we think that the pound would fall sharply, perhaps from €1.19 and $1.32 to €1.12 and $1.20.
- As the markets have priced in a high chance of this Thursday’s election delivering a Conservative majority there is little immediate upside left for the pound or gilt yields, although equities might still get a boost. There is, however, lots of scope for a negative market reaction if there is a different election outcome. In that case, we think that the pound would fall sharply, perhaps from €1.19 and $1.32 to €1.12 and $1.20.
- The 2% rise in the pound since the election was called shows investors agree with our view that a Conservative majority is the best outcome for the economy in the near term. We think GDP growth would rise a bit as Parliament would be able to pass a Brexit deal that puts the UK in a status quo transition period until at least the end of 2020. Fiscal policy is also likely to be loosened. (Our full election preview is here.)
- Chart 1 suggests that if this outcome were 100% priced in the pound would only rise from €1.19 ($1.32) to €1.20 ($1.33). Gilt yields might not move much initially either. But if we are right that the economy would strengthen enough thereafter to stave off an interest rate cut, the pound may reach €1.33 ($1.40) and the 10-year yield rise from 0.78% now to 1.25% come 2021. Having underperformed since the referendum, a Brexit resolution and fiscal stimulus might be a turning point for UK equities too. (See Chart 2 and here.)
- Given investors’ preferred outcome is pretty much priced in, there is much more scope for dramatic market moves if the Conservatives only get a very slim majority or fall short altogether.
- Because a very slim Conservative majority or minority government would give hard-line eurosceptics influence over Brexit, we’ve argued it’s the worst outcome for the economy in the near term. A small Conservative majority would probably allow Johnson’s Brexit deal to pass, but the Prime Minister might not have the political latitude to extend the transition period. In that case, the prospect of a no deal at the end of 2020 would drag down the pound, perhaps from €1.19 to €1.14 ($1.25). Meanwhile, the weaker outlook for the economy would probably cause interest rates to be cut and the 10-year gilt yield to slip to around 0.50%. If the Conservatives fell short of a majority altogether, the possibility of a no deal Brexit in January would return, exaggerating these moves and pushing sterling down to about €1.12 ($1.20).
- A labour-led coalition would be the biggest surprise and have the largest impact on the markets. On its own, Labour’s Brexit policy would be favourable for business and investor confidence. But equities would suffer as investors price in the party’s plans to raise taxation on firms, nationalise numerous industries and dilute existing shareholders’ stakes by giving shares to employees. (See here.) These concerns and a softer growth outlook would probably pull down the pound to about €1.12 ($1.20) too. (See here.)
- But it wouldn’t be a blood bath for gilts. While Labour would borrow a lot more than the Conservatives, low official interest rates, well anchored inflation expectations and the limited risk to debt sustainability mean gilt yields might only rise from 0.77% to 1.0% initially, and to 1.25% in 2021. (See here.)
- Overall, the mini surge in the pound over the past week suggests there isn’t much upside left for the currency even if the Conservatives win the election decisively. But if they fall just short, the pound would sell off sharply and gilt yields would fall. The biggest surprise would be a Labour-led coalition, which would not only hurt the pound, but also hit gilts and especially equities.
Chart 1: €/£ & Odds of a Conservative Majority
Chart 2: MSCI Indices (USD, 23rd June 2016 = 100)
Sources: Betfair, Refinitiv, Capital Economics
Sources: Refinitiv, Capital Economics
Andrew Wishart, UK Economist, +44 20 7808 4062, email@example.com