Observations on the UK General Election

Overview

No single party has secured enough seats to form a majority government in the UK general election, countering the consensus of an outright victory for the Conservative Party. The Conservatives won the most seats, but Labour performed more strongly than anticipated as the Scottish National Party weakened. The Conservative Party may seek to form a coalition, or a minority government with the support of independent candidates.

This outcome is a blow to the Conservative leadership, given initial expectations for a landslide win. Prime Minister Theresa May surprised many in April by calling an early election, which was intended to capitalize on favorable polls to secure her party a more comfortable majority.

We await further clarity on the results, but we believe this outcome will complicate negotiations on the UK’s exit from European Union (EU). We expect a period of uncertainty that could weigh on UK assets and add to economic headwinds.

Outlook

UK markets fluctuated as polling tightened ahead of the election, and we reduced some of our UK risk exposure. Looking ahead, we think:

Volatility in UK markets could pick up, weighing particularly on the British pound. This unexpected result will likely drive sharper depreciation in the pound, which surged when the election was called on the expectation of a Conservative landslide, and subsequently wavered in line with polls. We are underweight the currency, though we had reduced exposure ahead of the election. We also see potential pressure on UK government bonds if progress on fiscal consolidation encounters further setbacks, and we are currently positioned for UK rates to rise relative to other developed markets.
In the near term, political uncertainty could exacerbate economic risks. As noted in our Q2 Fixed Income Outlook, we think currency weakness and a lack of clarity on Brexit are likely to weigh on household disposable incomes and business investment decisions this year. The coming months of political reorganization could compound this effect and the implications for growth. We see opportunities in select UK large cap equities, but our exposure to the domestic UK economy is limited given the high proportion of revenue among FTSE 100 companies that comes from abroad. We are cautious on UK small cap equities, which have a more domestic orientation.
A 'soft Brexit' may now be more possible, but the path is less certain. Prime Minister May pledged a so-called 'hard Brexit' that would prioritize immigration control and remove Britain from the single market and customs union. Given the pro-EU stance of most potential partners, a coalition may entail compromise and a greater willingness to accept free movement of labor on the condition of retaining access to the EU single market. We believe this scenario would be supportive of growth over the longer term.