U.K. Snap Election - Can We Hope For A Softer Brexit Now?

by: Principal Financial Group

Seema Shah, Global Investment Strategist, Principal Global Investors

Free up some space in your busy political calendars, there is yet another date to add to your diary: the UK general election on June 8, 2017. Prime Minister (PM) Theresa May made the surprise announcement of a snap election just this week, after having repeatedly ruled out the possibility. Market moves were significant as investors tried to interpret the impact on Brexit. I am cautiously optimistic that this election may imply a “softer” Brexit is in the cards.

The Conservative party currently has only a narrow working majority with 330 Ministers of Parliament (MPs) out of 650, and had been expected to wait until 2020 for the next scheduled general election. However, at least one of the motivations behind calling an early election is clear: according to most opinion polls, the Conservatives are likely to increase significantly their majority in a new election. Certainly, PM May would only have called an early election if she is confident that she will win, thereby also strengthening her personal mandate.

Assuming that the polls are correct, a larger Conservative majority and a stronger mandate for PM May would have implications for Brexit negotiations. From my perspective, they are three-fold:

  1. Brexit is even more likely to happen. Come 2019, when the Brexit deal may be in the final stages of being agreed and passed in Parliament, PM May would be faced with notably quieter opposing voices from the Labour and Liberal Democrat parties.
  2. There is now greater likelihood that a transition period is adopted. Originally, the 2020 General Election had meant that a “phased exit” between the formal Brexit date of 2019 and the conclusion of a free trade deal – during which free movement and EU laws could still be accepted – was unlikely. With a stronger majority, a Theresa May led government would be expected to govern until 2022, and a lengthy transitional arrangement would be possible. In addition, if there was unanimous agreement from the European Union (EU), the point at which formal Brexit occurs could be delayed (although I still doubt the Tory government would approve this).
  3. In line with the previous point, there is a higher chance of a softer “hard Brexit.” A larger Conservative majority would dilute the influence of a few MPs who are pushing for a very hard Brexit. They think that the UK would be better off without any deal and a reversion to World Trade Organisation rules would be best – something that we and most economists believe would be detrimental to the UK economy. By dampening their influence, PM May would have more freedom to manoeuvre in negotiations. Indeed, in recent weeks, while PM May is still supportive of a hard Brexit, she has appeared to soften her approach, becoming more pragmatic about the realities of Brexit and more sympathetic to compromise.

Overall, a stronger Conservative majority would reduce the downside risks. But there is an alternative opinion which is difficult to dismiss. For a start, there is no way of knowing how much PM May actually sympathises with the “Remain” camp. Her more conciliatory comments of late could just be a more sensible way of approaching negotiations with the EU. It is also possible that she could end up with an even more Eurosceptic government – this is certainly possible if the Tories try to win votes from traditional Labour supporters in pro-Brexit constituencies in the North and the Midlands, and they lose pro-Europe supporters to the Liberal Democrats.

Currency markets clearly believe the snap election will result in a softer Brexit. Sterling has strengthened by around 2% against the U.S. dollar – although the magnitude of the move was largely due to the overwhelming “short” positioning by foreign exchange traders. By contrast, UK equity markets weakened with the FTSE 100 index down 2% on the day of the announcement.

Why the negative reaction from equity markets? The FTSE 100 index tends to weaken when the pound appreciates because the stronger currency can cut into earnings and sales made overseas by U.K. companies. There are also, of course, other developments in the world that are distressing global markets. The large drop in iron ore prices had already triggered a sharp sell-off in mining shares, pulling down the FTSE 100 by around 1%, before PM May’s announcement. Growing doubts about the U.S. administration’s capacity for tax reform this year have also been weighing heavily on sentiment. Current geopolitical tensions are particularly intense.

And finally, there is another, more significant, election looming. The first round of the French Presidential election will be held this Sunday, and there is an alarmingly close race between the top four contenders. Come Monday morning, France may have delivered the nightmare scenario of a run-off between two anti-EU candidates. Brexit would be a breeze compared to a “Frexit.”

UK politics are of course important. But for global markets, there are more pressing concerns on the horizon.

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