With the UK general election on 8 June fast approaching, the most recent average “poll of polls” from the Financial Times shows a fall in the Conservative lead from 20% to 9%. This is barely higher than the 6.5% lead the party secured at the 2015 election, which generated a 12-seat majority. Given that the aim of calling the election was to secure a greater working majority ahead of Brexit negotiations, it would seem logical for financial markets to respond to the tightening of the electoral race.
However, markets have barely budged. Ten-year gilt yields are merely three basis points (0.03%) higher than before the election was announced, whilst the pound sterling’s trade-weighted index is at exactly the same level. There has been no discernible change in daily volatility, and sterling remains in the middle of this year’s trading range.
Is the market correct to be so complacent? And how might it respond to an increasingly wide range of possible outcomes?
- A larger Conservative majority in Parliament. This is still the central expectation priced in to markets, likely explaining the muted reaction to date. As long as the Conservatives secure a greater share of the vote, Theresa May can claim victory and proceed with Brexit negotiations. This should elicit little market response.
- A change of government. Whilst still unlikely, if the electorate deliver a Labour-led government, we would expect higher yields in long-dated gilts and a rise in currency volatility. Initially, the focus on looser fiscal policy and an untested government could send the pound lower. However, if looser fiscal policy is accompanied by tighter monetary policy and a stable government, then it is quite possible that in time the pound responds more favourably.
- A weakened Conservative government. This would be the most politically challenging outcome and would almost certainly send the pound and gilt yields lower. Many investors would immediately worry about a challenge to Theresa May’s leadership of the Conservative Party, and be concerned that a greater reliance on every Conservative member of Parliament risks a more confrontational approach to Brexit negotiations.
Given the electoral uncertainty and lack of market volatility, we do not believe investors are being adequately compensated to take risk associated with the outcome of the election. We believe UK gilt yields look rich compared with U.S. Treasury yields, but this is based on a fundamental view of the resilience of the economy rather than a view on the electoral outcome. If we are delivered market volatility, we believe investors are better served by having scope to respond rather than by taking a view ahead of the event.
Mike Amey is PIMCO’s head of sterling portfolio management and a regular contributor to the PIMCO Blog.