The Complete UK Election Preview

By Tyler Durden
Created 05/06/2015 - 21:30

The UK General Election will be held tomorrow. The polls close at 10 pm.
We should have a pretty clear picture of the overall seat count by 5 to 6 am on
Friday morning. The result, as SocGen notes, is almost certain to be a hung
parliament.
Then the fun will really start.
The leader of the incumbent Conservative/ Liberal Democrat coalition
(David Cameron) stays in power until or unless it becomes clear that he
does not have the ability to form a new government. Most polls are
showing that the Conservatives will win the most seats but fall far short of an
absolute majority. That will then lead to a contest between them and the
Labour party to negotiate with the other parties to form some type of formal or
informal coalition. The first test of the new government will be the vote on
its legislative programme which is then presented in the Queens speech
(tentatively scheduled for 27 May). That vote should be in the early part of
June.

The main concern for the markets should be whether or not a

Conservative-led coalition is formed that is sufficiently supportive of the
Conservatives plans to allow them to hold the promised Brexit
referendum by the end of 2017.
Here are the possible outcomes (along with SocGen's probabilities)...

[16]

As a reference, here are 2010's results:

[17]

And here are the key features of tomorrow's election relative to that
result...
1) A reduction in Conservative seats and an increase in Labour seats;

2) A major fall in support for the Liberal Democrats who could easily see the
number of seats won fall to less than 30;

3) A surge in the SNP seats from 6 to maybe even more than 50;

4) The poor performance of the UKIP (UK Independence Party), despite its
heavy influence on Conservative party policy in recent years. As the chart
above shows, they won NO seats in 2010. They currently have two seats as a
result of defections from the Conservative party but they will be lucky to win
even one more seat than that. So, in the absence of the most unlikely
outcome of the Conservatives being only one or two seats short of a stable
government, UKIP would have no role in the formation of the next
government.
The opinion polls show Conservative and Labour to be neck and neck

[18]

SocGen concludes, there is a real choice between the broad fiscal plans
of the Conservative and Labour parties.

Labour would cut the deficit more slowly to allow a higher level of net
investment than the Conservatives plan. That is a defensible position,
worthy of debate at a time when financing costs are at record lows.

However, the key point for the markets is that both major parties have plans
to continue austerity at a pace that would satisfy the markets. Certainly,
the Labour party has been accused of being anti-big business but that is
something that, if true, would only have a gradual impact on the economic
future of the UK.

[19]

More immediately worrying for the financial markets would be if the

Conservatives were able to construct a form of coalition that allowed

them to deliver the promised Brexit referendum by the end of 2017. That
would create lasting uncertainty that could damage business and investor
confidence.
Deutsche Bank believes UK politics alone are unlikely to derail the
recovery or meaningfully change foreign appetite for UK assets, in the
short term at least and lays out 7 predictions for post-election UK...
Rather than try to guess the outcome, however, in this note we make a few
broad brush predictions about what the post-election UK will look like for
investors. Our conclusion is that while the politics is extremely uncertain, the
policy mix may undergo less rather than more change. Politics alone are
unlikely to derail the recovery or meaningfully change foreign appetite
for UK assets, in the short term at least.

[20]

For GBP, once the initial uncertainty over government formation has passed,
the focus should quickly turn back to the monetary policy outlook. On that
front, we still see the risks lying in earlier rate cuts from the Bank of England
than the market expects. For this reason we see value in using election
uncertainty as an opportunity to position into EUR/GBP shorts.

Prediction #1: Fiscal policy will be easier, but the deficit will fall
At the Budget in March, forecast tightening over the next five years fell from
5.5% GDP to 4.4% as the coalition abandoned its goal of a GBP 23bn surplus
by 2019-20, but the next two years were still projected to be roughly as
austere as at the start of the coalition.1 After the election, there is reason to
think this may change.

In the first place, Labour policy is less tight than implied by current forecasts.
As the IFS notes, the partys plans mean only moderate reductions in
departmental spending may be required. Under the increasingly likely
probability the SNP holds influence over the next parliament, policy could be
easier still. The party currently advocates rises of 0.5% public spending in real
terms. Note that even under SNP plans, Treasury analysis suggests that the
deficit would continue to fall.3 If the Conservatives were to remain in office,
current forecasts may not materialize. The party eased off austerity in the
middle of the last parliament as growth suffered, and there are question marks
over where additional cuts implied by their deficit plans will come from. The
party may also be helped by the improving growth outlook. Receipts have
started to improve in recent months, and the OBRs current growth projections
are on the pessimistic side of official forecasters. In sum, and as our
economist has noted, it may be helpful to look through the very noisy political
debate on the deficit, and focus instead on the underlying improvement in the
public finances. This has important implications for sterling, because the Bank
of Englands inflation and growth projections as of the February Inflation
Report are currently predicated on the very austere fiscal path outlined in the
December Autumn Statement. Easier fiscal policy should provide the bank
with more scope for monetary tightening.

Prediction #2: There will be no fiscal crisis, whatever the outcome

Even if fiscal policy were loosened, there seems little chance of a fiscal crisis.

In the first place, the structural deficit has halved over the last five years.
Perhaps more importantly, the markets understanding of fiscal risks has
moved on since 2010, when a genuine loss of investor confidence in the UK
finances was arguably on the cards. As the Eurozone crisis has shown, debt
and deficits are much more relevant when countries lack an independent
monetary policy. A lack of market concern is reflected in credit spreads, which
remain at pre-crisis lows. Third, the external environment is very favorable for
UK assets. The ECBs QE program had driven yields of core fixed income
negative across the curve. One of the obvious beneficiaries should be the UK.
The spread between 10-year UK and German yields is currently the widest on
record. Todays Bank of England data showed massive (GBP 26bn) foreign
buying of gilts in March, more than reversing outflows in the first two months
of the year.

Prediction #3: The UK will remain one of the most attractive destinations
for foreign investment
The last few years have been very positive for foreign investment. FDI inflows
to the UK have totaled over 8% of GDP since the fourth quarter of 2012,
financing around half of the current account deficit. The policy mix has played
an important role. The corporation tax rate has fallen from 28% to 21% over
the last five years, seeing the UK leapfrog above every OECD country save
Switzerland in terms of corporate tax competitiveness. On the margin, a
Labour-led administration would imply a moderately less positive investment
climate than a Conservative one, but the policy mix is not set for wholesale
change. The party favors keeping the corporation tax rate at its current low
level (against another 1% cut proposed by the Conservatives). We doubt that
other Labour party policies such as a mansion tax, changes to the nondomicile status of taxpayers and rises in the top rate of income tax, will result
in a foreign exodus. Significant changes to the tax treatment of non-doms and
foreign purchases of UK property were made by the current coalition
government over the last five years with no apparent effect on foreign
investors appetite for UK assets.

Prediction #4: A new Scottish referendum wont happen anytime soon

Last years Scottish independence referendum generated panic among
investors as it became apparent that a yes vote was a real possibility, with
potentially destabilizing consequences for the UK banking system and
economy. But even if the SNP were to hold the balance of power after the

next election, it seems unlikely that a new referendum would materialize soon.
The party made no mention of another referendum in its manifesto released
earlier this month. This should not be surprising recent polling suggests that
the issue ranks extremely low on Scottish voters priorities. Even if the SNP
wished to reintroduce the question over the next five years, the partys
leverage over a future Labour government may be overestimated (see
Prediction #6). A more likely date for the issue to be reintroduced is after the
Scottish parliamentary elections in May next year, assuming the SNP holds on
to its majority in the Scottish parliament. But it is also worth pointing out that a
future referendum would likely be less destabilizing than last years events.
Precisely because of uncertainty in September, authorities and businesses
are now much better informed about the risks of a Scottish exit, particularly
with respect to risks concerning the banking sector.

Prediction #5: An EU referendum may be good for the UK economy

Under the Conservatives, a referendum on the UKs membership in the
European Union would likely be held before 2017 following a renegotiation of
the UKs terms of membership. A Brexit could have severe consequences for
UK growth performance and foreign investment, and the potential impact on
business confidence leading into a referendum has been widely noted.6 Less
commented on, however, are the potential benefits that a renegotiation could
bring to the British economy. As our economists have argued, the UK is
uniquely placed to benefit from reforms to the EU Single Market and the
Department for Business Innovation and Skills has estimated that the potential
gains for British exports could add up to 7% GDP.7 A referendum may be an
ideal bargaining chip for the UK to remodel aspects of the EU in its favor. Of
course, this would depend on an in vote, but polls currently suggest a
majority in favor of staying in, particularly after a successful renegotiation.

Prediction #6: A Labour minority government would be more stable than

you might think
If no party wins a majority next Thursday, the UK faces the prospect of a
coalition or minority government. In the event that SNP support is required to
pass legislation in the House of Commons, an increasingly probable outcome
given the latest opinion polls in Scotland, the latter seems the more likely
option. Labour has ruled out a formal deal with the nationalists. Some have
argued that if the SNP held the balance of power, the result could be
destabilizing, but the partys leverage may be less than thought. Even if the

SNP found Labour uncooperative on key policy issues, it would not be

rational for them to bring down the government with a vote of noconfidence.

[21]

This would cause a new election, a possible future Conservative government,

and damaging Labour accusations that the SNP had voted down a
progressive administration (we outline the SNPs options on a decision tree
on the previous page). The party also looks set to perform exceptionally well
next week, with some polls suggesting a near clean sweep of Labours seats.
It is unclear why the party would want to risk these with a new election.

Prediction #7: There may be less change rather than more

Precisely because no party is likely to have enough seats for a majority, it is
difficult to envisage sweeping changes to the policy mix. The last five years
have seen the deficit cut in half, the employment rate reach a record high and
UK growth accelerate above any other advanced economy. Major challenges
remain, however. The current account deficit has reached a record, meaning
much-vaunted rebalancing has failed to occur. Productivity has also been the
weakest among any G10 country. This has important implications for wage
growth, which has been very slow relative to previous recoveries. Indeed, the
current fracturing of the UKs political environment can indirectly be attributed
to imbalances in the labour market. Pollsters find that a key explanatory
variable behind support for the UK Independence Party (UKIP), for example,
is lack of a university degree. 8 It is unclear whether any major party has the
solutions for these issues, but also doubtful that it will have the electoral
resources. On the other hand, the doom-laden predictions of certain
commentators are unlikely to materialize.
* * *
Finally, Goldman simplifies the decision process to three potential
outcomes. While there is a whole range of potential outcomes to the May 7
election, each of the most likely governmental combinations falls into one of
three broad groupings:
1. A Conservative-led government (either on its own or in coalition with
the LibDems). This is likely to be perceived as the most market-friendly
outcome, partly because it would come closest to maintaining the status quo
and also because the Conservatives stated aim is to reduce the budget deficit
through cutting current expenditure rather than by raising taxes. Set against
this, the Conservatives commitment to hold a referendum on EU membership
by 2017 and the increased risk of exit would likely be negative for investment
spending and UK assets.

2. A Labour-led government (either on its own, with the implicit support

of the SNP, or in a formal coalition with the LibDems) would shift the
balance of further fiscal adjustment away from spending cuts to tax increases.
Labours proposals include: raising the top rate of income tax from 45% to
50%; raising the headline corporation tax rate from 20% to 21% (offset by
measures designed to help small businesses); increasing the Bank Levy on
banks balance sheets, applying a second one-off tax on bank bonuses,

removing the non-domicile tax status and introducing a Mansion Tax on

residential properties worth more than 2 million. At the same time, a
government of this complexion would be less likely to contemplate a
referendum on Britains EU membership.

Of the potential Labour-led government combinations, financial markets would

likely respond more favourably to a Labour/LibDem coalition than to a minority
Labour government supported by the SNP on a confidence and supply basis.
(The Labour party has ruled out a formal coalition with the SNP.) In this
scenario, concerns are likely to emerge that reliance on the SNP would pull
the Labour government away from the centre to the left of the political
spectrum, as well as raising the spectre of distributional policies favouring
Scotland at the expense of the UK as a whole.

3. It is also possible that there will be no clear outcome to the election. If

no party (or coalition of parties) is able to form a stable government, a second
election could be called shortly after the first or a minority government might
attempt to struggle on. Again, the lack of clarity surrounding such an impasse
would likely be damaging for UK growth and assets.
* * *
The Bottom Line is that at the macro level the implications of the
election may be less pronounced than many anticipate. Monetary policy
has been de-politicised through the Bank of Englands independence.
Moreover, the formation of a coalition government is likely to involve
convergence towards centrist positions, while a minority administration that
pursues policies outside the mainstream would be unlikely to survive given its
fragile parliamentary basis. In either case, the political system is unlikely
to deliver radically different macroeconomic outcomes.
Sources: Bloomberg, Goldman Sachs, Societe Generale, and Deutsche Bank