June is the end of May

Theresa May’s gamble backfired epically. The Conservative Party has lost its majority, casting doubt on May’s position as prime minister and leaving the United Kingdom (UK) with an unstable government at a time when it desperately needs stability. Two weeks shy of the start of Brexit negotiations with the European Union (EU), UK politics has been plunged even deeper into the unknown.

Theresa May had originally called the snap election to grow the Conservative Party parliamentary majority and strengthen her hand in Brexit talks. Instead, contrary to widespread expectations, the Tories lost seats, while the Labour Party made strong gains, resulting in a “hung Parliament”, where no one party commands a majority.

Nonetheless, despite their disappointing results, the Tories still emerged as the largest party and therefore have the first option to create a government. They have agreed an alliance with Northern Ireland’s pro-Brexit Democratic Unionist Party (DUP), pushing them past the post and enabling the Conservatives to form a minority government. For her part, Theresa May’s future as leader of the Conservative Party is precarious. Her decision to risk, and ultimately lose, the Tory’s majority means that she is already receiving calls to step aside, some even from her own team.

When no election would have been better than a bad election

Theresa May’s campaign, widely regarded as disastrous, dramatically weakened her position. She damaged her popularity with a no-show at an election debate, a U-turn on social care, and vagueness with regards to Brexit plans. By contrast, Jeremy Corbyn, leader of the Labour Party, gained momentum from a low base with a focus on inequality, free education, and billions more in public spending. Labour’s votes were also boosted by the long-awaited appearance of young voters. Early reports suggest that 72% of 18-24 year olds voted (if only they had appeared a year ago, during the Brexit vote).

By far, the most important implication will be on Brexit negotiations. A month ago, I had a glimmer of hope that a strong Conservative victory would mean a “softer” Brexit. After all, the result was expected to provide PM May with a stronger hand in the approaching negotiations with the European Union (EU). But now, with the Conservatives having lost its majority, the power of the few Euro-skeptic hardliners has been magnified. Talks with the EU are due to begin in 10 days and compromises may be difficult to sell to those hard Brexiteers.

May’s tenuous position as leader of the Conservatives may also be negative for those hoping for a softer Brexit. Although she has refused to step down, commenting that “the country needs a period of stability”, a leadership battle could soon begin. Hardline brexiteers are likely to be amongst the candidates and could steer Britain away from the soft Brexit I had hoped for.

The EU’s reaction to this latest twist in UK politics is another unknown, but I suspect that Brussels is unlikely to make concessions. Europe has been surprisingly united in its reaction to Brexit so far, encouraged by the strengthening economy and also the series of pro-EU election victories in 2017. Early comments from Europe have not been encouraging and so, on balance, a soft Brexit looks less likely.

There is a caveat. The Conservative Party’s coalition with the DUP could also influence negotiations. While the DUP backs Brexit, it only wants a “frictionless border” between the UK and the Irish Republic. This requirement would prove difficult if the UK were to exit the customs union. What’s more, given the spectacular failure of the Conservative Party’s campaign, their approach to Brexit will likely be questioned. As a result, it could be difficult to see this election outcome resulting in a “harder” Brexit.

Market disMay

The Bank of England will be watching these developments closely. They currently face a dilemma of rising inflation and a slowing economy. Political instability and Brexit uncertainty could make their predicament easier; policy normalisation may need to be much slower if they want the UK to stay on its feet.

Sterling suffered an immediately negative reaction, weakening by around 2% against the U.S. dollar. This is not surprising – with uncertainty lingering heavily in the air, markets have not received what they really wanted. I would expect the pound to continue weakening over the coming weeks as the new government struggles to find its footing in the Brexit negotiations and as in-fighting over the party’s leadership begins. Over the longer term, the evolution of the Brexit negotiations will be far more important for the direction of sterling than the election result.

A form of hard Brexit is likely on its way. This would likely push the UK into a sustained period of economic and political uncertainty. So, as an economist, I anticipate a slow, but insistent, downward trend in sterling over the coming years. As a Brit, I hope I’m wrong.

 

 

Follow Principal Global Investors on LinkedIn

 

_________________________________________________________

Unless otherwise noted, the information in this document has been derived from sources believed to be accurate as of May 2017. Information derived from sources other than Principal Global Investors or its affiliates is believed to be reliable; however, we do not independently verify or guarantee its accuracy or validity. Past performance is not necessarily indicative or a guarantee of future performance and should not be relied upon to make an investment decision.
The information in this document contains general information only on investment matters. It does not take account of any investor’s investment objectives, particular needs or financial situation and should not be construed as specific investment advice, an opinion or recommendation or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding a particular investment or the markets in general. All expressions of opinion and predictions in this document are subject to change without notice. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that Principal Global Investors or its affiliates has recommended a specific security for any client account.
Principal Financial Group, Inc., Its affiliates, and its officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy (including by reason of negligence) arising out of any for error or omission in this document or in the information or data provided in this document.
Third party content, such as comments to this blog, is not reviewed by Principal Global Investors before it is displayed, although we may remove, alter, edit or adapt any such comments. Principal Global Investors does not endorse, authorize, or sponsor any third party content. Links contained in some blog posts may take you to third-party sites and Principal Global Investors makes no guarantees to the accuracy of the information provided.

t17060905lh