The end of the Conservative Party conference was supposed to usher in a
period of reduced tensions within Theresa May’s government, allowing it to
refocus on the Brexit negotiations, and the broader Conservative Party to
start the fight back against the opposition Labour Party (who now lead in
the polls). Instead an unfortunate combination of a security lapse, a loss
of voice, and the conference set falling apart, has once again left the
prime minister under pressure, and derailed the attempts to project calm.
To date the market reaction has been fairly muted. Sterling remains the
most sensitive to political uncertainty, and has lost 1% against the U.S.
dollar and 0.75% against the euro in the 24 hours after the speech. Gilts
are little changed.
We believe markets are right to be relatively relaxed about this most
recent bout of political volatility, but it is a useful reminder that the
UK political landscape remains vulnerable to change – and that these
changes could have very different market outcomes.
Most likely outcome: May continues, markets stay calm
The most likely outcome is that the prime minister remains in office and
completes the UK’s separation from the European Union in March 2019.
Ironically, May’s strongest card is that the tensions within the government
are such that neither competing faction has much appetite for a leadership
contest, for fear of losing to the other side or worse still triggering an
early election. That means that should she want to continue, there is a
good chance that she will be able to. In this scenario, a smooth Brexit
would allow sterling to recover, the Bank of England to raise interest
rates gradually, and gilt yields to rise further.
Alternative outcomes: Leadership election, market volatility
However, there are a range of alternative outcomes, each of which would
trigger greater market volatility.
A Conservative leadership election alone could easily take two to three
months from start to finish, which would run the clock further towards the
end of the Brexit negotiations in March 2019, and raise the prospect of a
more disorderly exit. At a minimum the uncertainty would put pressure on
sterling, and most likely cause gilt yields to fall as rate hikes are put
Less likely, but still plausible, is that a dysfunctional Conservative
leadership election triggers a vote of no confidence in the government and
a general election. Whilst further running the clock down, this would also
raise the possibility of a change in government to one led by the Labour
Party. By their own admission the Labour Party is still fleshing out parts
of their policy framework, but it is likely that higher debt financed
fiscal spending could put some downward pressure on UK assets (both
sterling and bonds).
In short, whilst the status quo of a Theresa May led government remains the
most likely outcome, there are a range of alternatives that investors
should consider. We still see UK bonds as relatively rich and sterling
modestly cheap, but it is important that investors acknowledge the degree
of uncertainty, scale appropriately and remain alert to the different
is PIMCO’s head of sterling portfolio management and a frequent
contributor to the