Economic and Political Update (1)

The unnecessary and unexpected general election has led to a political risk premium now being factored into the outlook for the UK economy and financial assets. Investors and savers frequently ask what are our views on the political outlook.

Political uncertainty prevails

The minority Conservative government faces both tough EU negotiations and difficult decisions at home. It is possible to predict many scenarios. The most likely is the government remains in power, without an early election, and that negotiations with the EU dominate the focus in the second half of the year. A leadership challenge to the Prime Minister is also possible, adding to the political drama, but this is not our expectation: we expect Theresa May to remain as PM for now.

Given the political climate, the early October Conservative Party Conference, plus the September conferences of the other parties, will likely attract more financial market attention than usual. Labour will be pushing for an early election while the Conservatives will be seeking to prevent one and trying to regain the political initiative. Labour is likely to push for increased government spending as their policy focus. Indeed, as we approach the autumn Budget (likely in November and the second Budget of this year), the Chancellor will come under pressure to relax fiscal policy, and if he does, then this should be positive for economic growth next year.

If there was to be an early general election - say in the next year - then the outcome would be hard to predict. The current thinking in the markets is the likely combination of events that could trigger an early election could see a Labour victory - in their own right or as a coalition, triggering a significant shift in economic policy. But as a senior Labour politician recently said, one lesson from 1974 (when there were two elections in February and October) was that, despite what the media said at the time, when it came to it, people didn't really change their view too much when a general election is held again in a short space of time.

Brexit Budget needed in autumn

While that is conjecture, the Brexit talks are not. The current phase is on the divorce bill, Northern Ireland and EU citizens. The talks will move into their next phase and thus gather importance after the German elections this autumn. Regardless of these negotiations, there is much the UK can do itself to make Brexit a success. This, in turn, will make the autumn Budget even more important than usual. In the spring Budget, Brexit was barely mentioned by the Chancellor; in contrast this has to be a Budget that prepares for Brexit.

Favourable global climate

The good news is that this more difficult domestic climate is taking place in a far more favourable global economic environment. We have been at the positive end of expectations for the global outlook over the last year, and this has been borne out by events. We hope, and expect, this to continue. Global growth is holding up well, and this should be positive for both world trade and UK exporters, with the latter benefiting from a weaker pound, the question being whether this is reflected in higher margins or increased export volumes.

The world economy is enjoying reflation: with solid growth in western economies. Also, while inflation worldwide is higher than a year ago, it is not particularly elevated by historic standards. The combination of growth plus inflation, known as nominal growth, being much higher than policy rates and long-term yields is presenting a favourable backdrop for financial markets. This should continue during the remainder of the year, allowing government budget deficits to improve.

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