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 aperiod of reduced tensions within Theresa May’s government, allowing it torefocus on the Brexit negotiations, and the broader Conservative Party tostart the fight back against the opposition Labour Party (who now lead inthe polls). Instead an unfortunate combination of a security lapse, a lossof voice, and the conference set falling apart, has once again left theprime minister under pressure, and derailed the attempts to project calm.

To date the market reaction has been fairly muted. Sterling remains themost 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. Giltsare little changed.

We believe markets are right to be relatively relaxed about this mostrecent bout of political volatility, but it is a useful reminder that theUK political landscape remains vulnerable to change – and that thesechanges 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 andcompletes the UK’s separation from the European Union in March 2019.Ironically, May’s strongest card is that the tensions within the governmentare such that neither competing faction has much appetite for a leadershipcontest, for fear of losing to the other side or worse still triggering anearly election. That means that should she want to continue, there is agood chance that she will be able to. In this scenario, a smooth Brexitwould allow sterling to recover, the Bank of England to raise interestrates gradually, and gilt yields to rise further.

Alternative outcomes: Leadership election, market volatility

However, there are a range of alternative outcomes, each of which wouldtrigger greater market volatility.

A Conservative leadership election alone could easily take two to threemonths from start to finish, which would run the clock further towards theend of the Brexit negotiations in March 2019, and raise the prospect of amore disorderly exit. At a minimum the uncertainty would put pressure onsterling, and most likely cause gilt yields to fall as rate hikes are puton hold.

Less likely, but still plausible, is that a dysfunctional Conservativeleadership election triggers a vote of no confidence in the government anda general election. Whilst further running the clock down, this would alsoraise the possibility of a change in government to one led by the LabourParty. By their own admission the Labour Party is still fleshing out partsof their policy framework, but it is likely that higher debt financedfiscal spending could put some downward pressure on UK assets (bothsterling and bonds).

In short, whilst the status quo of a Theresa May led government remains themost likely outcome, there are a range of alternatives that investorsshould consider. We still see UK bonds as relatively rich and sterlingmodestly cheap, but it is important that investors acknowledge the degreeof uncertainty, scale appropriately and remain alert to the differentpossibilities.

Mike Ameyis PIMCO’s head of sterling portfolio management and a frequentcontributor to thePIMCO Blog.

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Disclosures

The terms “cheap” and “rich” as used herein generally refer to a securityor asset class that is deemed to be substantially under- or overpricedcompared to both its historical average as well as to the investmentmanager’s future expectations. There is no guarantee of future results orthat 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, andliquidity risk. The value of most bonds and bond strategies are impacted bychanges in interest rates. Bonds and bond strategies with longer durationstend to be more sensitive and volatile than those with shorter durations;bond prices generally fall as interest rates rise, and the current lowinterest rate environment increases this risk. Current reductions in bondcounterparty capacity may contribute to decreased market liquidity andincreased price volatility. Bond investments may be worth more or less thanthe original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities mayinvolve heightened risk due to currency fluctuations, and economic andpolitical risks. Investors should consult their investment professionalprior to making an investment decision.