Under Pressure: How UK Politics Is Influencing Markets

Under Pressure: How UK Politics Is Influencing Markets

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 on hold.

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 possibilities.

Mike Amey is PIMCO’s head of sterling portfolio management and a frequent contributor to the PIMCO Blog .

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Disclosures

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks. Investors should consult their investment professional prior to making an investment decision.