UBP | According to the latest polls, the Conservative Party is set to return to government with a decent majority. The polls have not narrowed meaningfully, as they did in the 2017 general election, meaning that investors are increasingly confident of a Conservative general election victory. A lead of between eight and ten points should equate to a majority of between 30 and 50 seats under the UK’s first past the post system.
A Conservative government with a large majority has a number of important political and economic implications:
- i) Removal of Brexit uncertainty: A Conservative majority means the new government will be able to ratify the EU Withdrawal Agreement before the end of December. The predicted majority implies that the new government will not have to rely on the support of the Democratic Unionist Party (DUP), meaning that the DUP will be unable to frustrate or stonewall the ratification of the EU Withdrawal Agreement. FX markets have largely priced this in; GBP/USD risk reversals, which show the cost of an option to purchase GBP relative to the cost of an option to sell GBP, have moved in favour of options to purchase GBP.
- ii) Removal of Labour threat: Institutional and private investors are petrified at the prospect of a Labour government. This explains why some UK assets, such as mid-cap equities trade at significantly lower multiples than their continental European equivalents. The prospect of a Labour government, alongside Brexit related uncertainty, has led to severe underinvestment in UK assets over the last four years.If the Conservatives gain a large majority, it will likely result in a relief rally for some UK assets. GBP’s recent up move seems to reflect the increasing prospect of a Conservative general election victory.
- iii) Fiscal stimulus: If the Conservatives return to power with a large majority, we anticipate the new government will engage in a large scale fiscal stimulus. The UK’s Chancellor of the Exchequer, Sajid Javid, has indicated that he will borrow to fund spending plans. Given the incredibly low level of interest rates, this is a sensible and pragmatic policy. Increased fiscal stimulus may result in better growth outcomes in the short term. This is much needed, given the poor performance of UK PMIs in recent months.
iv) GBP appreciation: If the Conservatives gain a large majority, GBP can continue its recent appreciation trend. The consensus narrative suggests that GBP/USD can move to levels of around 1.35. We note that US economic data have printed poorly in late November and early December. Consequently, markets may begin to price in FOMC monetary policy easing in early 2020, which will weigh on the USD and result in further GBP/USD upside.
We also note that liquidity tends to be quite poor in December, so any general election induced GBP/USD up move could be quite aggressive and take the market by surprise. Bottom line, we think a move to levels of around 1.35 or even 1.37 is entirely feasible. Over the longer term, we think GBP/USD can rise to levels of around 1.40 or even 1.45. We estimate GBP/USD fair value is at levels of around 1.45; but we note that in an FOMC easing cycle, GBP/USD could overshoot these levels.
