Could Theresa May’s gamble sink sterling?


Last week’s election result in the UK was the latest in a long line of political earthquakes that have shaken financial markets over the last 12 months.  Theresa May’s attempt to stabilize the UK political landscape prior to commencing Brexit negotiations had precisely the opposite effect; the UK now has weakened political leadership and a polarized electorate just as it is about to enter negotiations which will fundamentally re-shape the country’s economy.  However, the effects of unexpected events on currency markets are notoriously difficult to predict; whilst conventional wisdom indicates that the UK election will lead to a weaker pound, it is equally possible to argue that last week’s shock result will push the currency higher. 

 

 

 Let’s start with the obvious.  There are three reasons why the election result could damage the UK economy and lead to a weaker currency:

 

  1. Uncertainty – Markets generally don’t like political uncertainty and the UK now seems set for an extended period of political turbulence. A minority government, even one supported by a formal confidence and supply arrangement with a small regional party (the DUP) is inherently unstable.  Any policy disagreements, over Brexit or anything else, could effectively bring down the government, leading to new elections and even more uncertainty. 

 

  1. Corbyn – Jeremy Corbyn is now a hair’s breadth away from running the country. Love him or hate him, he is undeniably one of the UK’s most left-wing political leaders in a generation, and his hard-left agenda, which include higher taxes and industrial nationalization, would be anathema to international investors. 

 

  1. Brexit – Theresa May called the election to strengthen her hand in the Brexit negotiations. Her hand has now been considerably weakened – this could damage the effectiveness of the UK’s negotiating strategy, leading to a poor deal which harms the UK’s economic prospects. 

 

 

The above arguments are certainly plausible, and they explain why sterling sold off in the aftermath of the election, dropping almost three big figures from 1.30 to 1.27.  However, a more constructive case for sterling can also be made based on the following factors:

 

  1. Scotland – Before the election, betting markets indicated that the pro-independence movement would likely win the next Scottish referendum. After the election, with the SNP losing a substantial number of votes and MPs, bookies are not even offering a market in Scottish independence, as it is no longer considered a realistic possibility.   One of the greatest political risks facing sterling has therefore been effectively eliminated.  

 

  1. Political deadlock – is not always a bad thing. Theresa May’s agenda was not pro-business. Famously, her ill-fated manifesto made the Corbyn-esque claim that: “We do not believe in untrammelled free markets” and “a conservative government would strengthen the hand of regulators”.  Not music to the ears of foreign investors, meaning the much less ambitious political agenda that we are likely to see post-election may actually be a net positive for the UK economy. 

 

  1. Brexit – The weakening of Theresa May’s negotiating hand may result in a better Brexit deal, at least from a purely economic standpoint. It is very difficult to interpret voter’s intentions, but it is plausible to see the result as supportive of a pragmatic, rather than an ideological, approach to Brexit. Practically, this would mean prioritizing the economy and trade, and giving ground in areas such as immigration and the size of the final settlement.

 

 

Our current GBP forecast is neutral in the short term (3 months) and bullish in the longer term (12 months +).  Whilst the downside risks to this view have increased since last week, we are inclined to leave these forecasts where they for the moment. We will be keeping a very close eye on UK political developments in the days and weeks ahead, with a view to downgrading these forecasts should it become clear that the Conservative government’s position is untenable and / or the likelihood of a second general election begins to grow.  

 

 

Author: Kevin Lester



 

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