UK Election: Conservatives Form Minority Government

The financial markets misjudged the election outcome. For the second time this decade, Britain has elected a minority Conservative Government - the last time from 2010-15 it ruled in coalition with the Liberal Democrats. This time it will be supported by the Democratic Unionist Party (DUP), albeit not in a formal coalition. This will add to political uncertainty, particularly ahead of the Brexit negotiations.

The 10pm exit poll provided a huge surprise but was confirmed as the night progressed. Mind you, as the election campaign unfolded, such an outcome became less of a shock. The Conservatives were the largest party but came short of an overall majority, with 318 seats (and one yet to declare that they are expected to win). With 650 seats in total, 325 are needed for a majority (allowing for the speaker). But because Sinn Fein, which won 7 seats, does not take them up, this reduces the actual number needed in reality to 322 seats. With support from the DUP and its 10 seats, the Conservatives have reached the necessary requirement. Labour has 261 seats, SNP 35 and the Liberal Democrats 12.

The impact on markets

Electoral surprises can have unpredictable effects on the financial markets and it is sometimes best not to jump to too many conclusions about the eventual market impact. President Trump's election victory last November is probably the clearest recent evidence of this, where after an initial knee-jerk reaction, markets generally took the result well. It is hard to imagine that happening this time here in the UK, but it may take a few days for the politics to settle down and for the markets to digest this.

The UK election result not only contradicted most of the opinion polls, but more particularly completely contrasted with the parties' own polling, with significant regional variations. Even on the eve of the poll, the Conservatives were still expecting a huge majority and the financial markets were basing their expectations on these.

Political risk could weigh on UK assets

The big issues that the markets will focus on are, what does it mean for domestic economic policy and for Brexit? The initial market reaction has been for the pound to weaken. Because of the potential uncertainty ahead, there could be increased market volatility, with sterling in particular vulnerable. Gilt yields will be higher than previously expected, but not by much. While for equities, we should not forget the improving global economy. A softer sterling usually helps the FTSE100 too.

If sustained, sterling's weakness will reinforce trends already evident, adding to near-term imported inflation and giving a further competitive boost to exports. It was that rise in inflation - which is set to squeeze real incomes this year - that made many question the decision to call this election.

For now, the result should have a neutral impact on monetary policy, with rates remaining low until policy makers are able to assess the overall impact on the economy. Political risk has increased because of this election result and that will weigh on UK assets.

Next steps

The Conservatives are the largest party but with a minority Government.  In the February 1974 election, when Harold Wilson formed a minority Labour administration, there was a second general election that year in October. The possibility of another election cannot be ruled out, at any time. Meanwhile, the results suggest a second Scottish independence referendum is now off the cards. Theresa May looks set to remain PM but a challenge is possible at some stage - although it is not clear who would replace her without there being demand for another general election. Thus her immediate task should be to demonstrate that this new set-up can work. There are likely to be few senior Cabinet changes in the new Government.

The Conservatives will have a Queen's Speech to outline its legislative agenda on June 19th. One would not expect it to be voted down.  The Opposition may not want to try and force another election just yet. They would instead want to hold fire - building and raising finance for another election at some stage in the future were the Government to falter. Also one would expect the Queen's Speech to be relatively uncontentious, in order to allow the Government to focus on the imminent Brexit talks.

The impact on domestic policy and Brexit

Labour won the campaign and one would expect that to impact the Government's domestic policy in an indirect way. The outcome should confirm that austerity is dead, and that makes sense. How this will impact fiscal policy is unclear. The Labour Party correctly identified that the economy needs increased spending in key areas of infrastructure. An underlying message from voters, both in this result and in last year's referendum, is a need for increased regional spending. Student loans should be revisited too. One would expect the Conservatives will reassess their fiscal plans but no immediate change is likely. Often overlooked is that the improving global economy, alongside low bond yields, is creating an improving environment for the budget deficit to fall.

At a stroke, Theresa May has weakened the UK's hand in the Brexit negotiations. Despite it being declared by her to be an election about Brexit, there was little debate in the campaign about it. That debate, surely, has to be had in more detail in Parliament now. But there is no majority view on Brexit in the Conservative Party or in either the Commons or the Lords.

It would be premature to conclude too much regarding the talks. David Davies seems likely to lead the Brexit talks and his strategy will be unchanged but, with another UK election always possible, it will be interesting to see whether the EU proceeds at a slower pace in its approach. But the market thinking will be that a ‘soft Brexit’ now becomes more likely than a ‘hard Brexit’. The trouble is the terms ‘hard’ and ‘soft’ mean different things to different people. The Government needs to make clear the reason for the approach it wishes to take: being outside the Single Market and customs union and then seeking to agree a comprehensive trade deal. Interestingly, the DUP, like the Conservative manifesto, advocates a clean break.

The hard-to-predict Brexit outcome could add to business uncertainty and dent investment plans - or, at least, that is what most economists and in turn the market will assume. The gilt and equity markets may worry about what the combined impact of political and Brexit uncertainty will have on economic growth prospects.

Even though the Conservatives won they are not amongst the winners, which include: Jeremy Corbyn, Ruth Davidson, Soft Brexit and increased fiscal spending. It remains to be seen whether gilts and equities will be among the winners too. The next few days may help determine that.

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