The UK General Election result: what does it mean?

The UK general election concluded with the shock result of a hung parliament, with the Conservatives the largest party. High levels of youth turnout, enthused by Labour’s radical manifesto, a strong showing for Labour amongst remain voters, and a failure of the faltering UK Independence Party (UKIP) vote to break for the Conservatives meant that the landslide victory Prime Minister Theresa May had hoped for failed to materialise. Also important was a shift in political dynamics in Scotland, where the Scottish Nationalist Party (SNP) lost 21 seats, including their former leader’s and current House of Commons leader’s, and finished with barely half the vote share of the unionist parties.

In this blog post, we discuss the implications of this.

Who governs?

The results leave the Conservatives only just short of a majority. A Queen’s Speech bill could easily be passed with the support of the Democratic Unionist Party (DUP), a conservative unionist party in Northern Ireland. At present, it does not appear that a formal coalition will be sought; rather, the Conservatives will seek DUP support for key bills, such as budgets, and any Brexit-related legislation (a “confidence and supply” agreement).Theresa May has stated categorically that she will not resign, even though it is far from clear that a majority of the party support her continued leadership. The Conservative parliamentary party could remove her through a vote of no confidence.

The Labour party’s Jeremy Corbyn, for his part, has declared his intention to attempt to govern as a minority party. Theoretically, Labour can write a Queen’s Speech and ask other parties to support it in parliament. The parliamentary arithmetic is very difficult, however, which makes this scenario unlikely. If Labour does propose a Queen’s Speech, it is likely a political move, designed to put the Liberal Democrats and SNP in a difficult position, as much as anything else. It looks very difficult to Corbyn to implement the bulk of his manifesto, with his party so short of a majority.

Brexit

Brexit negotiations are due to start on 19th June, ten days on from the result. The most immediate question is who will now be responsible for negotiating on behalf of the UK. For the moment, May remains Prime Minister (and hence responsible for representing the UK) and if the Conservative party attempt to remove her, it is not clear what timetable will apply to this, and it is very unlikely that a successor could be selected before 19th June. If May goes into the negotiations with questions marks over her position (which is likely) then EU negotiators are unlikely to take her position seriously, and little headway is likely to be made. As yet, there have been no conversations over whether the negotiations could be postponed to account for this in the event that May was facing a leadership challenge.

As for the substance of the deal, this election result shifts the balance of power in multiple, complex ways. On the one hand, if May is forced to rely on the DUP for support, then they are likely to demand a Brexit deal which avoids a “hard border” between Northern Ireland and the Republic of Ireland, which is very difficult to square with fully ending free movement of labour. Furthermore, the government may end up depending on some Labour party votes to pass the final Brexit “great repeal bill”, which would allow the party to extract significant concessions on access to the single market and membership of the customs union. On the other hand, if the intention of calling this election was to dilute the influence of hard-line pro-Brexit Conservative MPs, it has decisively failed. Whether a Conservative leader will be able to remain leader of the party without satisfying the demands of the right-wing of the party remains an open question.

Further elections to come?

One possibility is that the Conservative party will try to resolve the political instability Britain now faces with another general election, which they hope would deliver a majority government. Senior Conservatives have stated that they will not allow Theresa May to run another election campaign, which means that this would have to happen after a leadership election. It would be a highly risky move: it is unknown how the electorate would react to another election. It would also cause further delay to Brexit negotiations.

Scottish Independence

A final important implication of the election is that Scottish independence has become much less likely. The Scottish electorate significantly turned against the SNP, effectively wiping out any mandate their leader, Nicola Sturgeon, may have for a second referendum on the issue. The long term implications for British politics and the constitution are murkier, but this reduces a significant risk for the Brexit process, that the SNP will baulk at the direction of negotiations and credibly demand a second referendum on independence which could break up the United Kingdom. This crucial development which removes one source of political risk should not be underestimated.

Overall, this election result leaves the path of the UK much less certain. The type, content, and time scale of the Brexit negotiations has been thrown up in the air. Though a Conservative government is likely to continue, it cannot be taken for granted that May will remain its leader. And there could be more elections, more uncertainty, and more drama to come…

Brexit: how bad could it get?

  • In April we noted the uncertainty that a Brexit vote would bring to the British economy.
    In this post, we examine how the economic risk the UK now faces may be manifested in a post-Brexit UK.
  • In particular, we look at a “worst case scenario”, and what this might mean for the economy, and the currency.

As we argued in April, the Brexit vote has plunged the UK into economic uncertainty. Questions abound about the relationship the UK will have with the EU after exit, and even about the government’s negotiating position. The government has not yet made its position clear, with Government spokespeople issuing contradictory statements about future membership of the single market and the customs union.

A vital issue for the UK is that of passporting: members of the single market (also the European Economic Area, or EEA) continue to be regulated by their domestic regulator whilst they provide cross-border services or establish branches in other EEA economies. This has historically been a significant driver of reduced transactions costs for inter-EU trade in financial, legal and consulting services. The EU’s MIFID II (Markets in Financial Instruments Directive) provides for third countries (non-members of the EEA) to retain limited passporting rights provided those countries retain regulatory “equivalence” with the EU. The government’s silence on this suggests that continued access to the EEA is far from assured, and the stakes are huge. The UK’s financial sector is hugely productive, providing £67bn in tax revenue and £19bn in exports just to the EEA.

So how bad could it be? One way to shed some light on this question is to look at how the fair value of sterling would shift if the UK was without the productivity boost of the financial sector. We know that the productivity of the South East has supported the UK economy. So what would happen if this was all lost?

The answer is given in Figure 1. In the event that the UK’s financial sector flees, with attendant productivity declines, the UK would fall from roughly the same level of GDP per capita as Germany to that of the EU average. The relationship between productivity and real exchange rates (the Balassa-Samuelson effect) suggests this would mean a depreciation equivalent to sterling falling to 1.142 against the dollar.

Figure 1 Source: IMF WEO, OECD, ONS, Macrobond, Record. Real exchange rate calculated using Purchasing Power Parity. GBP excluding London is calcualted by assuming that GBP per capita falls to the level outside London, and taking the predicted exchange rate from a regression. Data correct as of September 2016 (last release of GDP and PPP data).

Figure 1 Source: IMF WEO, OECD, ONS, Macrobond, Record. Real exchange rate calculated using Purchasing Power Parity. GBP excluding London is calcualted by assuming that GBP per capita falls to the level outside London, and taking the predicted exchange rate from a regression. Data correct as of September 2016 (last release of GDP and PPP data).

Naturally, whether this will be manifested is still highly uncertain. We still do not know how far the government prioritises access to the single market, or how effective they would be in negotiating access. It is not even known how far the loss of passporting would actually affect UK firms.

However, even the depreciation implied by the loss of the entire City of London is not a significant decline beyond the depreciation since June (see Figure 2). This has fascinating implications. Is the market already pricing in a highly destructive Brexit? Is political uncertainty weighing on sterling more than the fundamentals justify? And could it be that the worst is behind us?

Figure 2 Source: OECD, IMF WEO, Macrobond, Record. The projected exchange rate move under the estimated scenario is shown by the dotted lines.

Figure 2 Source: OECD, IMF WEO, Macrobond, Record. The projected exchange rate move under the estimated scenario is shown by the dotted lines.

Market Volatility: the Brexit Premium

  • The uncertainty associated with the outcome of the referendum on Britain’s EU membership is already affecting financial markets and the wider economy. By examining the pricing of derivatives, we can identify the price the market is putting on this uncertainty, and what movements in currency are expected between now and the referendum itself.

“All I know is that I know nothing.” Socrates

For all the bluster from both the Bremain and Brexit camps in the EU referendum debate, very little can actually be known about the pros and cons of British economic life outside the EU. Yes, there are an unknown but certainly large number of jobs linked to British trade with the EU. Undoubtedly, some of these would go. At the same time, we have no idea what the relative importance of the loss of these jobs, and, on the other side of the ledger, reduced regulation and import substitution, and the ability to make our own trade deals, would be.[1] Similar stories can be told about the FDI and investment flows on which Britain is so dependent, although there is already evidence of a negative effect on the London Housing market.

What is known is that in the event of Brexit, article 50 of the Lisbon treaty plunges the UK in to an (at least) 2 year-long negotiation on the terms of exit, in which the only thing that is certain is that the range of potential outcomes is huge. The one thing markets hate is uncertainty, but how much uncertainty does the market expect?

Source: Bloomberg Data

Figure 1 Source: Bloomberg Data

3-month At-the-Money implied volatility (the expected level of volatility) and ‘risk reversals’ (a relative measure for the cost of insuring sterling downside against the euro) for EURGBP options spiked on 23rd March (the first day which brought the referendum within range of these measures). This is reflective of a “Brexit Premium” priced in by sellers of options who are clearly expecting potentially huge moves on the day.

We can use options to price the expected price moves on the day, as well. As the delta of an option is (roughly) equal to the market’s estimate of that option’s being exercised, for different strike rates, we can construct a probability density function, which looks like this:

Source: Bloomberg data. CDF is constructed from the deltas of options with different strike prices. The PDF is constructed by calculating the gradient of the PDF at different points. Data correct as of 25/04/2016

Figure 2 Source: Bloomberg data. CDF is constructed from the deltas of options with different strike prices. The PDF is constructed by calculating the gradient of the PDF at different points. Data correct as of 25/04/2016

We can see that there is significant tail risk, here. If the UK leaves the EU, a significant depreciation of sterling could be on the cards. What should not be overlooked, however, is that in the (likely) event that the Bremain campaign triumphs, there could equally be a not-insignificant appreciation of sterling. Those positioning for further sterling depreciation (that is, non-commercial traders on net, see figure 3) should be wary of this tail risk as well.

Figure 3 Source: Bloomberg Data

Figure 3 Source: Bloomberg Data. Non-commercial positioning is the net long position of traders classified as non-commercial in Sterling futures and options.

In summary, the overwhelming message from markets is one of uncertainty and volatility. As is often the case, Socratic scepticism is the order of the day…

 

[1] For a discussion of these issues, see R. Bourne (2015) “The EU Jobs Myth”. Institute of Economic Affairs, Breifing 15:02.