UK election outcomes and financial markets

With less than a day to go before voting begins we think that it is worth getting some bullet points down to remind investors how financial markets tend to react to UK elections. We’ve also added some extra bits of information that could be interesting for your trading in the next couple of days.

• Our base case is that the Conservatives will win and gain a slim majority, basically this would mean that nothing much will change from this election. The latest YouGov Model sees Labour winning 269 seats, compared with 334 seats for the Conservatives, which would be a slim 8-seat majority.
• In the past, financial markets have tended to prefer Conservative victories, GBP jumped 1.5% in 1992, and 2% in 2015. However, this time it could be different. GBP bulls are not only dependent on Theresa May winning the election, it also depends on her majority. A slim majority of 8 seats, as predicted by YouGov, is likely to arouse fears of a hard Brexit, as the 50 or so Eurosceptic MPs in the Conservative Party could sway the negotiations. This could spook GBP traders.
• If this happens then we would expect GBP/USD to slip back towards the 1.25 level that cable was trading at before Theresa May called the election on 18th April.
• If Theresa May can win a larger majority, of say 40-60 seats, then we think this may boost sterling, although we believe that the market is already positioned for a Tory Party majority, hence the relatively muted response in GBP to the sharp narrowing of the opinion polls in recent weeks. Thus, GBP/USD may not get much further above 1.30 even if May wins a decent majority.
•  JP Morgan sees a 1.3% gain for the FTSE 100 on the back of a Conservative majority on Thursday night.
• Historically, a win for Labour tends to be pound negative, although we believe that Labour’s prospect of a soft Brexit could boost sterling, and we could see GBP/USD climb back above 1.30 towards 1.32 on this outcome. Concomitantly, we may see a sharp fall in the FTSE 100 as elements of the Labour manifesto may worry UK stock investors.
• The FTSE 250 has recently underperformed the FTSE 100, as UK midcap traders start to fear this election outcome. Thus, a large majority for Theresa May could see this index rally, and potentially outperform the FTSE 100 in the short term.
• A hung parliament could be the worst outcome for sterling, as it would create a whole new level of uncertainty. In this scenario we would expect a sharp drop in the pound and the FTSE 100. While we would expect the FTSE 100 to recover in the short-term, we could see GBP/USD fall below the 18th April level at 1.25 and back towards 1.20. If we get a hung parliament then it could take time to form a government, which could delay Brexit negotiations and make the 2-year deadline to get a deal seem even more unrealistic. Sterling has been the conduit through which traders have expressed concern over Brexit, thus we would expect the pound to suffer the most if there is no clear winner from tomorrow’s election.

Why a win for Labour may not cause market meltdown

As mentioned above, the market is positioned for a Conservative majority, thus any other outcome has the potential to disrupt markets; but by how much? This depends on how much traders want to risk, which will then determine volatility in UK asset prices in the aftermath of the election.

While a victory for Labour would be a “shock” for the markets, the market impact may be contained. While we would expect an initial decline in sterling and a sharper decline in UK share prices on the back of investor fears about Jeremy Corbyn’s left wing agenda, the impact could be short-lived as investors start to trust the machinery of UK government that limits a candidate with a radical agenda. This can be seen in the US, where markets have continued to rally even though Donald Trump has proposed some market negative, and frankly preposterous, policy ideas, which traders assume won’t see the light of day because of the US system of checks and balances on a President’s powers.

Thus, markets may have little to fear if Corbyn wins on Thursday night. Stock market gains under a Labour government aren’t unheard of either. Under Tony Blair’s premiership, the FTSE 100 rallied nearly 50%.