Ruling Britannia

The UK faces its most uncertain election in a generation. The electorate’s declining appetite for traditional parties – the ruling Conservatives and centre-left Labour – means the race is unlikely to produce a majority winner.

Who will rule Britannia – and what would this mean? We debated post-election scenarios and their implications for UK fiscal policy and asset prices, taking a deliberately apolitical view. Our main conclusions:

• Opinion polls and betting sites suggest the most likely outcome is a weak coalition government: a Labour-led coalition with informal support from the Scottish National Party (SNP) or a less stable repeat of the current alliance between Conservatives and Liberal Democrats.
• A loss of support for major parties, the peculiarities of the UK’s ‘first-past-the-post’ constituency system and the rarity of political coalitions mean it could take several weeks or more to establish a new government. This would be business as usual in the rest of Europe, but it is unusual and somewhat harrowing for the UK.
• A Labour-led government reliant on SNP support for key votes would raise the spectre of a disunited kingdom. Imagine a similar situation in Spain if the central government were dependent on Basque or Catalan separatists, or a Canada beholden to the Parti Québécois.
• A soothing outcome for markets is hard to imagine. Labour would be tough on business – and might be perceived as lacking fiscal responsibility. A Conservatives-dominated cabinet would pave the way for an unsettling referendum in 2017 on the UK’s European Union (EU) membership. Whoever wins – and the result could take time to emerge – will lead a weak government likely to pass only watered-down legislation.
• UK markets have been relatively calm, suggesting a smooth and swift government handover. We believe this view is too complacent – and expect volatility in the currency and other UK assets. Retaining international investor confidence is key: gaping current account and budget deficits make the UK particularly reliant on the kindness of strangers for financing.
• The main financial challenge for any new government will be cutting the budget deficit. The major parties mostly agree on the direction of adjustment but disagree on how to get there. Conservatives prefer spending cuts to tax hikes, while a Labour-led coalition would likely cut the deficit at a slower pace. The SNP, by contrast, favours more generous welfare and health spending. The problem? Weak productivity growth undermines the success of any fiscal plan.
• Backtracking on the pace of deficit reduction would likely lead to a temporary sell-off in gilts and steepen the yield curve. It could also result in a rise in inflation expectations and bring forward the timing of interest rate hikes. Yet we do not see a lasting election impact on UK fixed income assets. Issuance of gilts is set to fall as the UK deficit shrinks – and a steady bid from pension schemes and other long-term asset owners should dampen any yield spikes.
• UK equities and corporate credits could perform poorly because new governments tend to front-load austerity measures, denting consumer confidence. A Labour-led coalition would threaten the profitability of highly regulated industries such as banking (higher bank levies, more competition) and utilities (pressure to lower energy bills). Housing-related equities look attractive due to both major parties’ support for the industry.

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