UK elections and the equity market
by George Hatjoullis
According to the FT, “Investors fret over UK general election” (http://on.ft.com/1BtSstg) and the main concern is the risk of exit from the EU. This is a very odd concern. First,the implication is that exit from the EU will have a negative effect on the value of companies that are quoted on the London Stock Exchange and make up various UK-based stock index benchmarks. This is far from self-evident. One could identify some companies that would be adversely affected but equally some that might be positively affected. The large capitalisation companies are global operations and would not necessarily be materially impacted one way or the other.
Second, there is the implication that it is conceivable that an exit might arise in the meaningful future. It would require a Conservative Party victory with an outright majority in order to get to a referendum by 2017. It will then require a vote from the country for exit. There will then be a long delay in order to reconcile the separate wishes of Scotland, Wales and Northern Ireland. The idea that Westminster could impose an EU exit on these countries against their wishes seems improbable. Finally, once reconciliation is achieved, assuming it is, the UK begins the process of negotiating exit. In the most unfavourable scenario, an UK exit is some way off.
Third, there is an implication that the Conservative Party might achieve an overall majority. This looks highly unlikely. The betting money, which I trust far more than opinion polls, suggests either a minority government or a coalition. The UK parliament has 650 members so an outright majority requires 326 seats. Taking the latest offer prices for number of seats from IG Index, the money is betting on Cons. 288, Lab. 279, Lib Dem. 26, SNP. 38, UKip. 8 and 11 other, including the Green Party. The main parties are long way off an overall majority and two-way coalitions look challenging. The choice is likely to be between a minority government consisting of the largest party or a three-way coalition or arrangement of co-operation. In these circumstances the House will find it challenging to pass a finance bill let alone agree a referendum on exit from the EU.
Of course, there is time for the situation to change. The election is on May 7. Moreover, the ‘money’ may be wrong. Nevertheless, the concern of the UK equity markets should not (yet) be the possibility of UK exit from the EU but rather with the prospect of a minority government or a three-way coalition. A minority government is much less of a concern than a three-way coalition. Minority governments are not that effective and thus cannot do much harm (or good). A three-way coalition is another matter. A Labour/SNP/Green coalition or agreement of cooperation could certainly make domestic business conditions less auspicious for profits. However, even this outcome is hard to achieve based on the current betting.
The major risk to the UK (and US) equity market in 2015 comes not from politics but the central bank. Both the Bank of England and Federal Reserve are dismissive of the risk of deflation. This implies interest rate increases are not too far away. The start of an interest rate hiking cycle could unsettle equities. Moreover, raising interest rates may quickly prove to be a policy error. If deflation is a greater risk than the central banks grasp an interest rate increase could be very damaging to economic activity and earnings. The economists and policy makers at central banks were educated during a period when inflation was the economic policy concern and fear of inflation is deeply rooted. Moreover, there is a deeply held belief in the intrinsic inflationary tendency of modern economies. This could distort their thinking and policy actions. Policy makers are, unfortunately, usually found to be perfectly equipped to tackle the last problem and not the one that confronts them.