The UK Economy: A Post-Election Update
After the shock of the general election, resulting in a hung Parliament and minority Conservative Government, what are the implications for the economy and investors? In terms of the political outlook, three scenarios strike me as likely. First, and most likely, the Conservatives remain in power, with the support of the Democratic Unionist Party (DUP) - thus avoiding an early election. This would require a much watered-down legislative agenda. The country does not want another election, but the other scenarios would include this possibility. The implications for Brexit are covered below.
Second, there is another election by next spring. If this were to happen then it would most likely be because something has gone wrong - such as the Government losing a confidence vote - and in this scenario a Labour victory might be seen as likely. Of course that is not clear-cut, as they came second in this election with 262 seats - 56 behind the Conservatives. Even though it seems inconceivable that Theresa May would lead the Government into such an election, in this scenario her replacement will not have had time to win. Third, the Government calls an early election and, led by the new leader, wins.
The fact that these three scenarios are all possible, and by only next spring, highlights how much of changed political environment the UK now finds itself in. As a result, political risk overhangs all UK assets, with sterling - as usual - the most vulnerable. But, most likely, another election will be avoided and the focus of Government’s attention will be on the Brexit talks with the EU. The Conservatives have 318 seats. The party needs 322 seats for a voting majority (in total there are 650 seats in the Commons, minus one speaker and seven Sinn Fein members who do not attend Parliament) - hence their need for an arrangement with the 10-seat DUP. This means that the legislative agenda, in the Queen's Speech, will be relatively thin in order to minimise the risk of it being voted down.
Political uncertainty: the impact on the economy
While this political uncertainty is a worry for the markets, another is the impact on the domestic economy. Over the last year, in line with our forecasts, the economy has been relatively strong in the wake of the referendum result. This was helped by the expected stimulus from a weaker pound and monetary easing, plus solid consumer spending and still high levels of inward investment. But even without this unexpected election, the UK looked like it was losing momentum. Consumer spending was likely to slow, as real wages were squeezed by higher inflation - a trend that looks set to continue through to early next year as inflation rises further - while wage growth is modest. Now, in addition, as a consequence of the election result, business confidence looks vulnerable and this could weigh on investment and other construction activity.
Even without a hung parliament, there was a possibility of the uncertainty surrounding the EU negotiations dampening business sentiment. Admittedly, ahead of the election business confidence was holding up well. But now, the uncertainty from a hung parliament, plus the risk of another election, will weigh on confidence. This has already dipped since last week, according to the Institute of Directors. All this could also weigh on UK domestic equities, while gilt yields stay low. The good news is that UK export growth should continue to benefit from a competitive pound and the solid growth being seen elsewhere in the global economy.
The outlook for UK fiscal policy
It would be wrong to suggest the election points to a change in Brexit strategy, not least because domestic factors seemed to dominate much of the seven-week campaign. As a result of these factors, fiscal policy will likely be relaxed. Indeed, during the election campaign the Conservatives had already indicated this, saying that they would delay by five years until 2025 the time period over which they intended to return the budget deficit to a surplus.
Since the election result, the Prime Minister has apparently indicated that austerity is dead - a view it is difficult to disagree with. Hopefully this will suggest increased infrastructure spending later this year. The country needs more transport links in the north and more housing in the south, and the latter can be helped by also easing current constraints on house-building. An immediate change in fiscal policy is unlikely, particularly as the Chancellor, Philip Hammond, has been reappointed to his role, and we will likely have to wait until the autumn Budget to hear more.
Meanwhile, interest rate policy is likely to remain unchanged. Inflation pressures are building, as the Bank of England has previously expected, but domestic cost pressures remain subdued. Although sterling has weakened slightly in the wake of the election result, this is unlikely to change the interest rate outlook. In fact the Bank should be concerned about the negative impact of a hung parliament on business confidence.
Brexit strategy
The other issue of note is the impact of the election outcome on the imminent Brexit talks. It would be wrong to draw too many conclusions from the election for Brexit in terms of public opinion. But the parties that did campaign actively on a more pro-EU stance performed poorly. While both the Conservatives and Labour were against remaining in the single market, and received around 83% of the vote, the reality is that many if not most people would have voted on domestic grounds, not least the need to boost public spending. Even though public opinion may not have changed, the numbers in Parliament have and this may yet result in a change in Brexit strategy. This is a topic to which we will return in the coming weeks.
We already know that the initial issues when the UK and EU meet on the 19th June include: the rights of EU citizens in the UK, the fiscal bill the UK will have to pay for leaving and the issue of Northern Ireland and the border with the Irish Republic. It was always expected that the EU negotiations would add a further degree of uncertainty to UK assets, but now we have the additional problem of political risk. Given the election outcome, that is unlikely to disappear anytime soon. But if it results in a more relaxed fiscal stance, then this, together with a slightly more competitive pound and continued low interest rates, may help offset some of the slowdown from a hung parliament on consumer and business confidence.
Second, there is another election by next spring. If this were to happen then it would most likely be because something has gone wrong - such as the Government losing a confidence vote - and in this scenario a Labour victory might be seen as likely. Of course that is not clear-cut, as they came second in this election with 262 seats - 56 behind the Conservatives. Even though it seems inconceivable that Theresa May would lead the Government into such an election, in this scenario her replacement will not have had time to win. Third, the Government calls an early election and, led by the new leader, wins.
The fact that these three scenarios are all possible, and by only next spring, highlights how much of changed political environment the UK now finds itself in. As a result, political risk overhangs all UK assets, with sterling - as usual - the most vulnerable. But, most likely, another election will be avoided and the focus of Government’s attention will be on the Brexit talks with the EU. The Conservatives have 318 seats. The party needs 322 seats for a voting majority (in total there are 650 seats in the Commons, minus one speaker and seven Sinn Fein members who do not attend Parliament) - hence their need for an arrangement with the 10-seat DUP. This means that the legislative agenda, in the Queen's Speech, will be relatively thin in order to minimise the risk of it being voted down.
Political uncertainty: the impact on the economy
While this political uncertainty is a worry for the markets, another is the impact on the domestic economy. Over the last year, in line with our forecasts, the economy has been relatively strong in the wake of the referendum result. This was helped by the expected stimulus from a weaker pound and monetary easing, plus solid consumer spending and still high levels of inward investment. But even without this unexpected election, the UK looked like it was losing momentum. Consumer spending was likely to slow, as real wages were squeezed by higher inflation - a trend that looks set to continue through to early next year as inflation rises further - while wage growth is modest. Now, in addition, as a consequence of the election result, business confidence looks vulnerable and this could weigh on investment and other construction activity.
Even without a hung parliament, there was a possibility of the uncertainty surrounding the EU negotiations dampening business sentiment. Admittedly, ahead of the election business confidence was holding up well. But now, the uncertainty from a hung parliament, plus the risk of another election, will weigh on confidence. This has already dipped since last week, according to the Institute of Directors. All this could also weigh on UK domestic equities, while gilt yields stay low. The good news is that UK export growth should continue to benefit from a competitive pound and the solid growth being seen elsewhere in the global economy.
The outlook for UK fiscal policy
It would be wrong to suggest the election points to a change in Brexit strategy, not least because domestic factors seemed to dominate much of the seven-week campaign. As a result of these factors, fiscal policy will likely be relaxed. Indeed, during the election campaign the Conservatives had already indicated this, saying that they would delay by five years until 2025 the time period over which they intended to return the budget deficit to a surplus.
Since the election result, the Prime Minister has apparently indicated that austerity is dead - a view it is difficult to disagree with. Hopefully this will suggest increased infrastructure spending later this year. The country needs more transport links in the north and more housing in the south, and the latter can be helped by also easing current constraints on house-building. An immediate change in fiscal policy is unlikely, particularly as the Chancellor, Philip Hammond, has been reappointed to his role, and we will likely have to wait until the autumn Budget to hear more.
Meanwhile, interest rate policy is likely to remain unchanged. Inflation pressures are building, as the Bank of England has previously expected, but domestic cost pressures remain subdued. Although sterling has weakened slightly in the wake of the election result, this is unlikely to change the interest rate outlook. In fact the Bank should be concerned about the negative impact of a hung parliament on business confidence.
Brexit strategy
The other issue of note is the impact of the election outcome on the imminent Brexit talks. It would be wrong to draw too many conclusions from the election for Brexit in terms of public opinion. But the parties that did campaign actively on a more pro-EU stance performed poorly. While both the Conservatives and Labour were against remaining in the single market, and received around 83% of the vote, the reality is that many if not most people would have voted on domestic grounds, not least the need to boost public spending. Even though public opinion may not have changed, the numbers in Parliament have and this may yet result in a change in Brexit strategy. This is a topic to which we will return in the coming weeks.
We already know that the initial issues when the UK and EU meet on the 19th June include: the rights of EU citizens in the UK, the fiscal bill the UK will have to pay for leaving and the issue of Northern Ireland and the border with the Irish Republic. It was always expected that the EU negotiations would add a further degree of uncertainty to UK assets, but now we have the additional problem of political risk. Given the election outcome, that is unlikely to disappear anytime soon. But if it results in a more relaxed fiscal stance, then this, together with a slightly more competitive pound and continued low interest rates, may help offset some of the slowdown from a hung parliament on consumer and business confidence.
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