Bloomberg: UK political chaos puts early election on traders’ radar

The indifference of British markets to the overthrow of Prime Minister Boris Johnson can change in the blink of an eye, notes Bloomberg.

Johnson’s ouster has increased the chances of early parliamentary elections, according to market strategists at NatWest Markets, Citigroup Inc. and Mizuho International Plc. It opens the door to a spending spree to fool voters before they go to the polls, followed by the prospect of the opposition Labor party coming to power and splashing out more money.

This will affect everything from Bank of England policy and taxation to the pound, bonds and stock markets – and will also see earlier risks re-emerge, such as a new Scottish independence vote and the resumption of negotiations for Brexit. While there are still many “ifs” and “buts,” the election has already seeped into investors’ minds.

“The prospect of an election alone would be arguably negative for the currency as broader political risk escalates,” NatWest analysts including Imogen Bachra said. “An earlier election and therefore more than expected fiscal easing raises the risks that the BOE will act more ‘aggressively’ in the second half of 2023 and longer-dated gold yields will rise.”

After three stormy years in office, Johnson’s reign appears to have come to a chaotic end after members of his government resigned en masse last week. His Conservative party is urgently drawing up plans for an accelerated contest to choose his successor this summer.

The next election will be held no later than January 2025, and Johnson’s successor will not be required to go to the polls earlier. Nevertheless, he may be tempted to take advantage of any political honeymoon in the first months of his term in the hope of locking in another five years of power and public legitimacy.

That prospect has already led the NatWest team to change its Bank of England (BOE) forecasts, expecting faster rate rises and a slower bond-selling program given the prospect of more government spending. They revised up their year-end 10-year yield target to 2.25%.

Yields have already bounced and closed last week near that level. The race to lead the government is heating up, with former chancellor Rishi Sunak announcing his candidacy on Friday.

“Nobody knows yet who the chancellor will be and what his or her approach to fiscal policy will be: will he tighten it, will he loosen it, will he be more concerned about regaining electoral support through tax cuts and handouts?” he said. Stuart Cole, chief macro economist at Equiti Capital, adding that he would not be surprised by a 2023 election showdown.

The picture for the pound, already down about 11% this year, is more complicated. While loosening the government’s purse strings or cutting taxes could boost the UK economy, they could also increase inflation and put public finances under pressure. The new leadership will bring other market-sensitive policy changes into play.

For the UK stock market, domestically oriented companies are likely to get a boost if a new leader raises questions over next year’s planned corporation tax hike. Britain’s mid-cap benchmark FTSE 250 is down around 20% in 2022.

More aggressive rate hikes by the BOE and a stronger pound could prove negative for the FTSE 100, where around 75% of companies’ sales are made overseas. Higher borrowing costs would also hit consumers and thereby retail stocks such as Next Plc and Marks & Spencer Group Plc.

“The political uncertainty comes at a time when sentiment towards UK equities is already poor – this appears to be reflected in lower valuations of UK companies in many cases relative to their overseas counterparts, as well as recent weak data on net flows of UK equities,” said Gabriele Foa, portfolio manager at Algebris Investments.

While rate hikes will widen profit margins for lenders such as Lloyds Banking Group Plc and NatWest, British banking stocks may remain under pressure as the country faces a recession. Investors in utilities and oil companies such as Centrica Plc and Shell Plc will be closely watching the push for a tax hike in the sector to help power bills.

As for the broader trade and political risk, some analysts point to the possibility of an improved relationship with the European Union. Johnson had pushed through legislation that would have given Britain the ability to unilaterally amend the post-Brexit arrangement for Northern Ireland, risking a trade war with the bloc. On the other hand, a new election could remove the existential risk of Scotland breaking away from the United Kingdom, given the Conservatives’ opposition to an independence referendum.

“We see the change in leadership as marginally positive for sterling through the increased likelihood of fiscal support and, in the medium term, a lower barrier to better relations with the EU,” said Shreyas Gopal, strategist at Deutsche Bank AG. However, any leadership candidate “showing a willingness to go to the polls will be seen as more negative for sterling given the additional uncertainty it will introduce”.

At the moment there are so many potential candidates that it is difficult to gauge what the views of the winner might be. Some analysts are wary that a new leader will risk going to the polls, given that the Conservatives still have a healthy majority in Parliament. Given the dire economic situation that Johnson’s successor will inherit, it would be a big risk.

The recent history on the success of such a strategy is mixed. Former prime minister Gordon Brown missed this opportunity to be forced out of office in 2010. Theresa May’s snap election in 2017 ended up costing her a majority, although Johnson himself was more successful in 2019.

“Certainly a new leader would want a mandate, but it would be almost impossible to achieve a majority close to what Boris Johnson achieved in 2019,” said Geoff Yu, senior currency strategist at Bank of New York Mellon. “An election showdown could lead to months or weeks at least of political deadlock, so it just wouldn’t be helpful.”