After all, coalitions are common in Europe, and the stability of the UK’s ruling Conservative-Liberal Democrat coalition has surprised many political analysts. Simply put, there is uncertainty over both the makeup of any coalition, and over the process by which it is formed.
Bookmakers’ odds suggest as many as eight plausible outcomes from the election, with a “stable” outcome in the traditional sense – a majority for one of the large parties, or a centre ground coalition – only a one-in-three probability. This opens the door for a period of uncertainty as the parties jostle to form a workable government.
Stepping back, there is a philosophical question of whether the UK is transitioning from a two-party political establishment to a multi-party system. One of the attractions of UK assets to international investors has traditionally been their perceived safe haven status – in large part reinforced by robust property rights and a predictable parliamentary system. While, fundamentally, either a two-party or multi-party system is perfectly legitimate and functional, the structural transition from one to another is not without risks and tensions.
The election on 7 May perhaps, in hindsight, will come to be seen as an important watershed in the transition from two-party to multi-party politics. As this transition plays out, it has the potential to introduce some volatility into UK assets and, for a time at least, to increase UK risk premia.
The last five years show that the UK is perfectly able to function under a coalition administration. However, the 2015 election is likely to feature a much closer race between the main parties and see a much greater influence from challenger parties. The formation of the Conservative-Liberal Democrat coalition in 2010 took only five days, and avoided meaningful market turmoil; but this time around, the backdrop may be more reminiscent of the political uncertainty of the early 1970s. The experience of a minority government in 1974 was less comforting: the minority Labour administration lasted only from April until October before a second election was called – delivering a three seat majority to Labour. Over that period sterling fell 5% vs. the U.S. dollar and UK stocks fell 43%, underperforming the U.S. by 22%.
In our view, most financial markets are pricing for an outcome that looks more like 2010, at the same time that political betting odds point to a level of uncertainty much more akin to 1974. We do not doubt that over time the UK will adapt to a multi-party system, if indeed that is the direction in which the country’s political landscape is evolving. But with any process there are growing pains, and the aftermath of the 2015 election could be a volatile period to navigate.
Another issue is the UK’s large fiscal deficit and the 5.5% current account deficit – the worst since records began in 1961. History suggests that the combination of twin deficits and political uncertainty tend not to end well for the pound. Thus, any outcome that is either perceived to raise the odds of the UK exiting the EU, or that compromises fiscal discipline, may be negative for the currency.
So how should a multi-asset investor think about the forthcoming election?
In our view, the currency is most immediately vulnerable. Not only is the political uncertainty a problem for sterling, but any outcome that dilutes deficit reduction commitments could quickly put the spotlight on the UK’s weak fiscal and trade balances. This alone may deter international investors from UK assets as a bloc.
History suggests UK equities respond poorly to political uncertainty, but at the same time UK stocks offer both attractive yield and defensive qualities. On balance, we believe that political uncertainty is a headwind, but one that will become more acute the longer the formation of a government takes following election day. Hence we maintain a modest underweight in UK stocks, but could become incrementally more negative if post-election negotiations drag on.
Gilts are supported by international duration demand, and uncertainty following the election could reinforce domestic demand for the UK’s “riskless asset”. However, Gilts would be vulnerable to any coalition that took a firmly anti-austerity position. While fiscal slippage is a risk in some coalition combinations, it is unlikely that even a very left-leaning coalition would fully reverse fiscal savings as an opening policy step.
In sum, we remain circumspect on UK assets ahead of the election with an underweight on sterling, and some caution towards UK stocks.
