The UK election and the end of the beginning?

Key takeaways

• We anticipate a Conservative majority, setting up the next Brexit phase
• If polls are correct, the UK’s full EU membership would end 31 January, kicking off potentially lengthy EU trade talks
• We expect more government spending and a modest rise in GDP growth next year
• Sterling is pricing out the no-deal Brexit premium, and we expect UK equities to begin to catch up with European stocks.

As we prepare for the UK general election on 12 December, we expect a Conservative majority government to deliver the next stage in the Brexit process, potentially setting the stage for higher growth. We remain overweight sterling.

Boris Johnson, the country’s incumbent Prime Minister, promises to “get Brexit done.” While the process will not be over any time soon, the election should at least bring some clarity on the way forward if Mr Johnson secures a majority.

Until 2015, the UK’s first-past-the-post electoral system tended to deliver majority governments. In 2005, for example, Labour under Tony Blair took 56.5% of parliament’s seats with 36.1% of votes. In the two elections since 2015, the Conservative 12-seat majority has slipped into a minority, providing the weakest legislative structures since the early 1970’s at a time when the country faces its greatest decisions in a generation.

Election scenarios

Now, the Conservatives are forecast to win 42% of votes and 359 of parliament’s 650 seats, which would give Mr Johnson a majority of 68 seats¹. Although traditional polls have a poor record in recent elections, crowd-sourcing data backs up this result, putting the chances of a conservative majority at 75%, a hung parliament at 25% and a Labour majority at 0%.

75%       Brexit alarm hits ‘snooze’

Assuming Mr Johnson remains prime minister with a sufficient majority, parliament should approve the Withdrawal Bill legislation marking the end of the UK’s full EU membership on 31 January 2020. That would kick off detailed trade negotiations with the EU and mark the end of the early stages of Brexit, rather than the conclusion implied by Mr Johnson. During the transition period, the UK will still be a member of many of the bloc’s frameworks, including the single market and customs union.

Trade specialists point out that no free trade agreement of any substance can be agreed in so little time. There is no precedent for negotiating a trade agreement in reverse – working to make trade more difficult. The EU-Canada trade agreement, cited by Mr Johnson as an example, took seven years to negotiate and will take several more for full implementation.

Another deadline looms. Before 1 July 2020, the EU and the UK will have to agree whether to extend the transition period for a maximum further two years.

“This is diplomatic amateurism dressed up domestically as boldness and decisiveness,” said former UK ambassador to the EU, Sir Ivan Rogers, on the publicly stated timing. Unless the 11-month timetable slips, the UK will have to make many concessions in the interests of securing a very basic agreement, he has warned.

25%       Here we go again? A second referendum

It looks highly unlikely that Labour could form a government on their own. The only possible alternative to a Conservative majority is therefore an alliance between the Labour Party and the Liberal Democrats, which would inevitably water down Labour’s nationalisation plans, higher corporation tax and mandatory employee stock ownership proposals, which have been labelled the most left wing agenda in 40 years. In fact, under this scenario, the most likely outcome would be a second referendum.

Yet, the polls could be wrong again and investors need to make sure they are prepared for any eventuality. If Mr Johnson’s Conservative Party sees its lead narrow to 7% or below, the risk of a hung parliament would rise. For investors highly geared towards sterling and UK equity upside, GBPUSD put spreads could act as hedges. GBPUSD implied volatility has declined, and optionality is now cheaper. A hung parliament, combined with an increased probability of a Corbyn led coalition government, would result in higher volatility and a sterling retracement, and this would benefit owning GBPUSD puts. UK investors would also profit from a more globally diversified asset allocation.

Economic outlook and assets

After three years of slower growth, we expect that the new government will increase fiscal spending, in line with both parties’ campaign pledges. That would provide the economy with a boost and the prospect of a modest pickup in real gross domestic product from 1.3% in 2019 to at least 1.4% next year.

Based on expectations for a Conservative government, the sterling market is currently pricing out the “no-deal” Brexit premium. We have been about 2.5% overweight GBPUSD in our portfolios since mid-October. Since then, the pair has risen by around 4%, and our target for the long sterling trade stands at 1.35. As long as our central UK political scenario holds (along with a weakening dollar), we believe that this position continues to make sense.

From a near-term perspective, and assuming the polls are right, UK equities will benefit from some reduction in uncertainty and we see earnings growth reaching high single digits in 2020. As we write, UK stocks are trading slightly above their 10-year median valuations; but of course, rates are now much lower than in the past. The FTSE 100 has underperformed the rest of Europe in 2019 and, while much of the lag looks related to the wider unpopularity of mining and banking stocks, we expect some catch up in the next 12 months. In contrast, the FTSE 250 may outperform as it is less affected by sterling.

Beyond the purely political noise of the coming days, the UK’s economy needs a boost to escape the coming impact of losing preferential access to its biggest trade partners’ markets. Since the Brexit vote, sterling has lost around 10% against the US dollar and inflation has increased from 0.5% to 1.5% year-on-year. Brexit has cost the UK economy between 1.7 and 2.5%² of GDP. Longer term, most academic studies suggest that the economic impact could be even greater, and Brexit could result in a GDP loss of between five to ten percentage points.