Brexit and political uncertainty to weigh on economy
It wasn’t supposed to happen this way. When UK Prime Minister Theresa May called for a snap general election on 18 April, she was way ahead in the opinion polls and seemed certain to secure a comfortable majority. The consensus was that a straightforward election victory would strengthen her hand as the country headed into Brexit negotiations with the European Union (EU). But what appeared a low-risk gamble has backfired, and the UK now has its second hung parliament in the last decade. What does that mean for the economy and investors?
We were concerned about the economy’s short-term prospects prior to the election. Growth fell significantly in the early part of the year and this weakness may well continue, given that low wage growth and rising inflation are squeezing household finances. At least as we enter a period of political uncertainty, it’s reassuring that UK employment is at record levels.
Meanwhile, sterling’s decline following the Brexit vote last year means British goods are cheaper for foreign buyers and one might have expected exports to lift off. But this has not happened.
Now there is a real risk the increased uncertainty generated by the election, which might be with us for many months, could lead households and businesses to pull back their spending even further.
The outlook for the pound also remains unclear with much depending upon the outcome of the Brexit negotiations. This is creating a further lack of clarity for businesses. Sterling remains more than 10% lower than prior to last year’s referendum on EU membership. That reflects the market’s view on the longer-term negative impact of the UK leaving the EU. But it probably doesn’t fully price in the negative implications of getting no deal with the EU. That would likely see sterling fall further. By the same token, a deal that allowed the UK to retain access to the single market would likely see sterling rise, perhaps quite significantly.
Higher public spending ahead?
In terms of government economic policy, the election result suggests voters are weary of austerity. The focus had already shifted away from austerity under the Conservative government. Independent analysis of the Labour and Conservative manifestos showed there was really very little difference in terms of the pace of reduction in the government spending deficit and eventual move into surplus. The Labour manifesto was more about the size and role of government than a change in the overall amount of spending. So we may now see higher public spending than might have been the case had the Conservatives won a comfortable majority.
In addition, the Bank of England will not be moving on interest rates any time soon and, if anything, the slowing economy could open up the debate for the deployment of further stimulus measures. Looser public spending and monetary policy should help to support the economy.
So what does all this mean for financial markets? Given our expectation for the UK economy to slow further, we expect the share price of firms that do most of their business in the UK to weaken relative to the overall stock market. The price of government bonds, or gilts, could decline; reflecting the uncertain political outlook and the potential for another general election, not to mention increased uncertainty over Brexit talks. The prospect of higher government spending could also weigh on gilt prices as the government issues more than expected. Like any product, when supply increases prices tend to fall.
There is, however, a limit to the extent that uncertainty is ‘catching’. Financial markets outside the UK are unlikely to be greatly impacted.
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