British voters once again defied conventional wisdom and the majority of pollsters by denying Prime Minister Theresa May the larger majority she hoped would strengthen her Brexit negotiating hand. Contrary to expectations, the Conservative party lost its majority and will now only be able to govern by relying on the Democratic Unionist Party (DUP) of Northern Ireland. Since the DUP had been voting alongside the Tories in the outgoing parliament, in theory, this should not change the general policy thrust of the UK government. Of course, in practice, this outcome will have dramatic effects.
Why Does This Matter?
First, Prime Minister May’s leadership is permanently weakened, even as Brexit negotiations are scheduled to begin next week. It is unclear when she will be replaced, but it is hard to imagine her leading the party into the next election after a series of unforced errors. A leadership challenge could emerge at any moment. Hence, the second consequence will be weaker party cohesion, diluting any policy initiatives. Intra-party dynamics will be critical to understanding future policymaking. May had shifted the party toward economic interventionism and accommodated the hard Brexit wing of the party. The election loss suggests the hard Brexiters will lose influence, though that depends on the makeup of newly elected members of parliament (MPs).
The future of EU–UK negotiations will turn on those new MPs. Since Brexit was not the main focus of the campaign, it is difficult to predict what the country’s negotiating stance with the EU will look like. The sequence of Brexit talks requires the Prime Minister first to ensure party support before submitting any deal to parliament. While that body is more pro-European now following the vote, it is unclear whether the parliamentary Tory party has moved in that direction. Many new conservative seats were won both in Remain-supporting Scotland as well as in Leave-supporting areas of England. The only certainty now is that the UK will fail to agree on a post-Brexit future with the EU before the deadline of March 29, 2019. That leaves two possible outcomes: a hard Brexit with no deal with the EU, or the UK could negotiate a longer, transitional arrangement with the EU that maintains most features of EU membership, including the free movement of people.
Establishment Politics Still on the Ropes
Above all, the UK vote signals that anti-establishment sentiment is still alive and well in some of the world’s major economies. In France, Emmanuel Macron was able to channel popular resentment into a centrist outlet. Last year’s EU referendum was also heavily driven by anti-elite feelings, with the Brexit vote rejecting both Brussels and Westminster. It is important to recall that the UK experienced the worst drop in real wages since 2007 among OECD countries, except for Greece. This frustration will remain in the body politic as protest voters do not align ideologically with any faction. While exact data is still forthcoming, it looks like UKIP voters from 2016 (and who voted 95% Leave) now split their votes across other parties, with only a slight majority of them voting Conservative – which campaigned as the new Brexit party.
Secondly, inter-generational tensions in the UK are shaping political outcomes. Age was the greatest predictor of Brexit voting patterns, with 64% of the 65+ group voting Leave whereas a majority of under-50 voted Remain. In the referendum, a much larger turnout by older Leave voters determined the final result. The reverse seems to have occurred yesterday. Young first-time voter participation has increased, helping to raise overall turnout closer to historical averages (see Figure 1). Extra turnout certainly helped Labour, as nearly all districts that witnessed a turnout boost of 5% or more, went to Labour.
While global market reaction to the surprise UK vote was muted, the British pound tumbled as expected. The pound had weakened in the final weeks of the election campaign, though markets still expected a Conservative majority. Therefore the initial reaction has been a move lower as international investors demand a higher risk premium. The pound fell around 1.5% against all currencies on the exit polls, remained around that level through the night before falling slightly more on the European open. However, there do not appear to be signs of panic or global contagion; option implied volatilities and skews have not changed significantly for the British currency.
In the short term, the most obvious result would seem to be uncertainty: given the UK current account deficit and resulting dependence on the “kindness of strangers,” as Bank of England head Mark Carney has said, this may well lead to Sterling weakness in the short term. However, the currency is already substantially undervalued against the dollar and euro, reflecting some degree of risk premium. Such undervaluations do tend to correct over long time horizons, and it is possible that the election result will lead to a softer Brexit, depending on the make-up of the final government. Sterling is likely to be weaker in the short term, returning to the lows of earlier in the year, with any move higher likely to be delayed until there is greater certainty.
Turning to UK equities there is a clear divide between domestically exposed companies and those with more international exposure, which are expected to benefit from a weaker currency. The main losers in this scenario are domestic retail stocks, retail-exposed real estate and domestic banks. The winners are likely to be autos and part manufacturers, chemicals, construction and materials.
While the most dire fears of European election outcomes for 2017 have been mostly averted, the UK shock has plunged one of the key advanced economies into political disarray. Moreover, this week’s testimony from former FBI Director James Comey in the US has darkened the cloud over Donald Trump’s administration and raised more questions over his ability to pass any of the stimulus legislation he campaigned on. In a global economy that was showing small steps in the right direction for stronger economic growth, the latest developments in the UK and US have raised the political uncertainty barometer again. So far global investors have shrugged off the latest twists. It remains to be seen if their complacency lasts.
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