Johnson, Corbyn, and the pound: An election guide – Special Report

Marios Hadjikyriacos, XM Investment Research Desk

On December 12, Britons will head to the polls to elect their new government, in what promises to be one of the most crucial elections in recent history. The result could decide what form Brexit takes, whether there’s a second referendum, and how much fiscal stimulus will be injected into an economy paralyzed by uncertainty. As for the pound, a clear Conservative majority would likely propel the currency higher, but even in that case, any rally may not be sustained for very long.

Political fatigue

Fragmented like never before and unable to decide on a way forward on Brexit, the UK Parliament chose to go back to the British public to break this deadlock – the fourth time in just five years that voters have been asked to determine their country’s future.

Make no mistake though, the stakes couldn’t be higher. The two main parties have entirely different visions for Brexit and radically different domestic economic plans. The only common ground is that both agree government spending should go up, but staunchly disagree on the size of that increase.

Echoes from 2017

One look at opinion polls would suggest the outcome is straightforward. The Conservatives are leading by a wide margin, polling in the 40-43% neighborhood. Meanwhile, the main opposition party – Labour – is around the 30% handle. Support for both parties has soared in recent weeks, with the Tories and Labour climbing in tandem since the election was called. Next come the Liberal Democrats, who are currently at 14%, but on a clear downtrend.

The problem is, polls are inherently unreliable in predicting UK elections. Recall the 2015 election surprise, the 2016 referendum upset, and the 2017 election shock? Pollsters failed to predict all of them, mainly due to the UK’s first-past-the-post system. It means that the seats in Parliament won by each party don’t depend on the percentage of the total vote they received nationwide, but rather on how those votes are distributed by region. For example, in 2017 the Tories captured 42% of the total vote but got 49% of the seats in Parliament, which is what determines who governs.

That wasn’t the only surprise back in 2017 though. Like now, most polls had Jeremy Corbyn’s Labour party at just 30%, but he managed to confound expectations and capture 40% of the vote. The point is, take polls with a grain of salt – they are useful for gauging sentiment, but don’t accurately translate into Parliamentary seats.

Brexit deal, another referendum, or cancel Brexit?

Now let’s examine the policies of the main parties. The Tories, led by Boris Johnson, are campaigning on delivering Brexit. They want to ‘Get Brexit done’ by pushing the deal Johnson has renegotiated through Parliament, even if doing so would only spell the beginning of the second phase of the negotiations, not the conclusion of Brexit. Domestically, they’ve pledged to increase annual spending by a modest £2.9 billion by 2022, focusing on healthcare, infrastructure, and public safety.

Labour has a much ‘softer’ Brexit vision. Corbyn wants to renegotiate a new deal in three months, vowing to keep the UK much more closely aligned with the EU. He then wants to put his deal to a second referendum, which will also include the option of remaining in the EU. What’s radical though, is the domestic agenda. Annual government spending would rise by £83 billion in four years, paid for by raising taxes on top earners and businesses to invest heavily in healthcare, education, social care, green energy, and renationalizing key industries.

The Liberal Democrats are proposing cancelling Brexit altogether, without holding another referendum. Economically, they would raise annual spending by £63 billion in five years, but claim they would still maintain a balanced budget, partly by raising income and corporate taxes and partly by the assumption that the economy would grow faster inside the EU, generating higher tax revenues.

Weird timing – a boost for whom?

Yet the most peculiar aspect of this election is the timing. The UK holds elections in the summer for good reason. The cold weather could discourage many – especially older – voters from exercising their democratic right. Likewise, this election coincides with several universities closing, so younger voters may also encounter difficulties. Overall turnout may be lower than usual.

Here’s the interesting part though: older voters tend to be pro-Brexit and vote Conservative, while younger voters are overwhelmingly pro-remain and vote Labour. Which party does this hurt more? Who is more likely to fire up their base to go out and vote anyway? That might hold the key to this election.

It’s striking that 3.1 million Britons have registered to vote since the election was called, which is 0.9 million more than the same number before the 2017 election. This reflects mostly younger voters, as the older ones are already registered, so net-net this argues for a better-than-expected showing for Labour.

The pound’s trilemma

The most bullish outcome for the pound would be a clear Conservative majority. It would likely end Britain’s political paralysis, allowing the negotiations to move forward and alleviating some of the uncertainty that has haunted the economy. In this case, sterling could skyrocket alongside the euro, to the detriment of the dollar and Japanese yen.

Another beneficial scenario may be a Labour-led coalition that promises a second referendum. It could also end the deadlock, but any positive reaction may be much smaller than an outright Tory win, given Corbyn’s tax plans. This outcome is unlikely however, as both Labour and the Lib Dems have been adamant they won’t form a coalition together.

The most catastrophic outcome for the pound would be a hung Parliament, where no single party gains a majority. The deadlock and the uncertainty would continue indefinitely, with no majority of lawmakers favoring any Brexit deal or another referendum, much like this last year. Even worse perhaps, as holding another election to break the new impasse would be out of the question.

Is any pound rally sustainable?

As things stand, an outright Tory majority or a hung parliament are the most probable outcomes, so the risks around sterling from the election appear balanced – something also endorsed by the sideways price action in Cable lately. Since it’s too close to call, not much is priced in and therefore, sterling will likely move sharply once the results start rolling in.

The initial reaction in the pound will probably last for a few days. Looking beyond that though, even in case of a strong Tory majority that raises hopes for the Brexit process to move forward, it’s still difficult to envision any rally in the pound being sustained for very long.

Johnson’s deal, if passed, would only mark the beginning of the second phase of negotiations, which may be even tougher than the first as this is where the thorny issues will be sorted out, such as the UK’s ability to strike trade deals with third countries and fishing rights. Painful compromises will have to be made, and as we’ve learned so far, neither side is willing to do that before the political pressure becomes overwhelming.

No-deal risk may return before long

The bottom line is that the political drama is far from over, even if the markets push the pound much higher on a Tory win. To be clear, the risk of a no-deal exit has not disappeared. Unless the two sides can reach a comprehensive trade deal by the end of 2020 – which is almost unfathomable – the UK will need to extend the transition period. That’s something Boris Johnson has repeatedly vowed not to do.

Hence, we could be facing down the barrel of a no-deal Brexit once again by this time next year – even sooner in fact, as the UK has until July 2020 to request an extension of the transition period. If Boris doesn’t, assuming he wins, then a no-deal exit becomes the default at the end of 2020, since there’s very little prospect to reach such a complex agreement in so little time. The EU-Canada free trade deal for example took seven years to negotiate.

The economy is another risk. GDP growth has remained positive, but recent PMI surveys show the economy is deteriorating quickly and that the labour market may be cooling, posing risks to future consumption. Two Bank of England policymakers voted for an immediate rate cut at the latest meeting to stimulate the economy, and it may be a matter of time before the rest come around to that view. With markets assigning only a ~35% chance for a cut by March, any signals that the BoE may indeed act would argue for a weaker pound in the months ahead.

All things considered, it’s difficult to envision a healthy and sustainable rally in the pound, even if the Tories win big. Political uncertainty isn’t going anywhere, and the economy could remain lackluster next year, keeping a ‘Brexit discount’ on the currency.