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Key Takeaways from the British Elections

Wells Fargo Investment Institute - June 9, 2017
Weekly International Update from Wells Fargo Investment Institute
  • Political developments in the U.K. once again captured market attention as the expected outcome of this week’s general election had come into doubt.
  • We address three key questions raised by some investors related to this week’s elections, particularly the topic of why the elections matter to financial markets.

What it may mean for investors

  • In the near term, we maintain a neutral view on U.K. stocks and a bearish view on its bonds and currency.

Download the report (PDF)

Voters in the U.K. headed to the polls on June 8, 2017, to elect members of Parliament following Theresa May’s decision earlier this year to call snap elections. The outcome of this week’s vote has resulted in the loss of the Conservative party’s majority in the House of Commons, but it still holds this most seats in Parliament. Theresa May’s ability to regain her post as the U.K.’s prime minister and form a government now has come into question, leading to further uncertainties related to the country’s process of leaving the EU (Brexit).   

Looking Forward

Over the past 12 months, investors have been presented with a number of notable political events in the U.K. which have had an impact on global financial-market sentiment in one form or another. With the latest batch of U.K.-related political developments in the rearview mirror, some investors have asked why this week’s elections matter to the markets and what, if anything, should be done as a result of the outcome.  In this week’s report, we address three key questions surrounding the U.K.’s general election and share our outlook going forward.

Why Were Elections Called in the First Place?  

Theresa May called snap elections back in April shortly after her government triggered Article 50 of the Lisbon Treaty, officially signaling its intention to leave the EU. It is widely believed that May’s decision to call snap elections had come from a desire to consolidate political power by increasing the number of Conservatives in Parliament. Prior to this week’s elections, the Conservative party held 330 out of 650 seats in the House of Commons.  

What Does the Outcome of the U.K. Elections Mean for Brexit?  

This question can be answered in two parts. First, the Conservatives’ loss of an outright majority could challenge its ability to govern. Nevertheless, the Conservatives could form a coalition with a smaller party, such as the Liberal Democrats (Lib Dems) as they did in 2010—although this outcome is highly unlikely given the Lib Dems’ opposition to Brexit. The Conservative party even could try to lead as a minority government, yet a great deal of compromise would be required to pass legislation. Ultimately, the lack of a single-party majority may foster greater instability in the U.K. government, potentially leading to another round of elections if the government fails.  

Second, we believe that government instability will challenge the U.K.’s power to effectively negotiate its exit from the EU and establish its new relationship with the region. Debates over “hard” versus “soft” Brexit could consume Parliament’s time and energy as efforts toward coalition-building move forward. If the government does fail, another set of elections will be called, likely before the end of this year. The European Commission has indicated that official Brexit discussions will not begin until it has a U.K. government with which to negotiate. In the meantime, the Article 50 clock will continue to tick toward the two-year exit period, reducing the amount of time that a future government has to negotiate an EU exit and increasing the likelihood of the U.K. simply stumbling out of its EU membership without any sort of agreement in place.  

What Does the Outcome of the U.K. Vote Mean for Financial Markets?  

The unfavorable outcome for the Conservative party can be viewed as a near-term negative development for global financial markets. Until recently, the U.K. elections were seen by many market participants as a nonevent, given the Conservative party’s strong position in popular polls. Yet, in the final days leading up to the elections, the Conservative lead-polling position over the Labour party narrowed, amounting to heightened levels of uncertainty regarding the U.K. vote outcome  and the future trajectory of Brexit negotiations. This uncertainty is likely to continue. If so, we believe that it will be reflected in U.K. (and, to a lesser extent, European) asset prices as a new government is formed.  Nevertheless, we believe that, to a certain extent, financial markets already have priced in a hard exit following Theresa May’s “no deal is better than a bad deal” position on Brexit negotiations earlier this year.  

Bottom Line

The outcome of the U.K. elections marks another surprisingly uncertain milestone in the country’s journey toward its exit from the EU. The Conservative party now has the difficult job of forming a government before Brexit talks with the EU can begin. When/if a new government is formed, the increased potential for domestic political upsets (including new elections) is likely to foster short-term periods of heightened market volatility as coalition partners attempt to reconcile views on the U.K.’s future relationship with the EU. Nonetheless, we believe that, to a certain extent, markets recently have priced in a hard exit from the EU, likely limiting the downside effects of ongoing political uncertainty in the U.K.

Over the next 12-24 months, we expect that the U.K’.s march toward its EU withdrawal in March 2019 potentially will have a negative impact on the country’s economy and lead to heightened volatility levels  in its financial markets. In more general terms, we maintain a neutral view on U.K. stocks and a bearish view on its bonds and currency.  For U.K. stocks, our neutral rating on British stocks (as part of a broadly-diversified exposure to European equities) reflects the positives of better-than-expected European economic and earnings fundamentals, balanced against the negatives of historically stretched equity-market valuations. Even in this context, however, we expect political uncertainties to drive heightened levels of market volatility.  

The low-rate environment in Europe, coupled with expected rate hikes by the Federal Reserve (Fed), continue to underpin our underweight asset-class recommendation on international developed-market bonds. Finally, while the British pound has strengthened versus the U.S. dollar heading into this week’s elections, we expect the pound to weaken through year-end as interest-rate differentials continue to expand when the Fed tightens its monetary policy while developed-market central banks abroad generally stay the course on accommodative monetary policy.