Britain in a right old pickle

9th June 2017 by Chris Iggo

Britain is in a right old pickle this morning. Britain really does not know what it wants. It has rejected the most left-wing policy agenda since the 1970s and at the same time rejected (almost) a government that did not appear to have a clear plan for the next parliament given that the next parliament will be dominated by Brexit. It seems that Britain is schizophrenic. It appears to want Brexit but is not sure what Brexit is. It wants more money spent on the health service and education but doesn’t want to pay for it via an attack on enterprise or at the cost of fiscal meltdown. It seems that young Britain is at odds with mature Britain. Scottish Britain doesn’t want to be on its own. Urban Britain looks to want very different things to rural Britain. And in the end, there was not enough faith in either Theresa May or Jeremy Corbyn to sway the results of the election decisively one way or the other. This morning, Britain is one big sovereign Confused.Com

Uncertain Smile – A few weeks ago I suggested that the UK election would be a good old fight between left and right, between a model of tax and spend against a model of fiscal conservatism and deregulation. At face value it was with the Conservatives getting an estimated 42.4% of the popular vote and the Labour Party receiving 40.1%. However, it has clearly been more than that given the massive differences in public opinion about Brexit and over social issues. The result, a hung parliament with the Conservatives as the largest party, means massive short-term uncertainty over domestic policy and over the UK’s ability to negotiate with the EU. The very superficial assessment is that a soft-Brexit is more likely, but I am not sure what that really means other than it puts the UK in an inferior negotiating position with the EU over the terms of Britain’s exit. “Soft” or “hard” may not actually be choices that can be made by the British side in reality. Until it becomes clear how that pans out, the economic risks are certainly skewed to the downside in my opinion as consumers and businesses are likely to delay making big decisions about spending, borrowing and investment. However, in the short-term we are not going to be getting nationalisation of the railway system and utilities, nor are we going to get corporate or income tax increases. Moreover, as expected, sterling is weaker on the back of the results and, as we saw in the aftermath of last year’s referendum, this could actually be a positive for growth and for the equity market (at least the large cap). So uncertainty centered on the immediate political outlook, the domestic policy agenda and Brexit.

Eur(ope’s) always on my mind – The collapse of New Labour in 2010 marked the beginning of this period of political uncertainty in the UK. David Cameron never really got a convincing mandate, having to rule first in coalition with the Liberal Democrats and then with a small majority that was largely delivered to him as a result of the desertion of many voters from Labour to the UK Independence Party as membership of the EU became the central political issue. The centrist consensus has been severely weakened because of the intensification of the divisions that have been created by Britain’s decades old inability to come to terms with being a European country. It is difficult to see how these issues are resolved in the short term. First there has to be some clarity on domestic political leadership which the outcome of the election precludes at this stage. Already people are talking about another election, or Theresa May resigning. If the Conservatives do press ahead as a minority government how will they sustain power and be in a better position next time around? The party may have to change but it will be the issues that will determine how people vote and the issues, away from Brexit, are about lack of wage growth, about concerns over the NHS and education and about inequality. All the issues that have been behind populism in many countries in recent years. In my view, Jeremy Corbyn tried to buy votes by promising more money for a whole range of things and perhaps the new, weaker, government may have to do the same. If 40% of the voting population were not that bothered about higher government borrowing, maybe the Conservatives should take some of Labour’s ideas and reflate the UK economy. I’ve long said, with long-term rates this low, why not borrow for investment and to boost real incomes? Let’s watch how the domestic policy agenda evolves in response to the inconclusive election result, but my bet is that if the Conservatives want to put a floor under their support they need to start to send a more positive message about the economy, about public services and about the quality of life for the great swathes of people that feel let down by globalisation.

Markets – So from a market point of view the clearest thing to say is that volatility is going to be higher to reflect the short and medium term uncertainties about Britain’s political and economic future. For now, businesses are not going to face higher taxes, increased regulation or threats of nationalisation, but investment is surely going to be affected by the Brexit uncertainty. Specifically for the gilt market there are three broad themes. The first is monetary policy. It is highly unlikely that the Bank of England changes interest rates in the foreseeable future and that is priced in to money market rates. Second is what happens to inflation. We saw last year that a weaker sterling pushes headline inflation higher and already break-even inflation rates have jumped on the view that this will be repeated. Third, and perhaps most important, is what happens on the domestic agenda. If the government sees the need to be more populist on the domestic side then this will mean more spending and more borrowing. The relaxation of fiscal austerity should lead to the steepening of the gilt curve. Currently the 10-year benchmark yield is 1.04% (having dipped below 1% this week). It peaked at 1.52% earlier this year and a move back to those levels looks entirely possible if the Tories respond to their poor showing by trying to curry favour with the element of the Labour vote that doesn’t necessarily want the full left-wing package but would like to see things done to ease pressure on the poorest in society. For sterling credit, the absolute move might be to higher yields but credit spreads themselves are not likely to move that much and could even tighten if there is a shift towards a more pro-growth stance.

Charity begins at home – The theme through all recent elections in the western democracies has been that there is huge popular concern about the impact of globalisation on incomes and inequality. The response to that has been to prioritise domestic agendas, even if in many countries more extreme positions have been rejected (I am not sure where to put the US in this context given that Trump did not win the popular vote in a two-horse race). In the case of the UK, the election means that there is less control over the key foreign policy issue of Brexit and it will be hard for a weak government to make any other case. It makes sense then, that after two horrendous errors of electoral judgment, the Conservatives resort to boosting the economy. After all, the argument for Brexit is that the UK would be better off outside of the EU. The British government needs to show evidence of that now. How that happens remains to be seen. If it doesn’t, then the downside to the UK economy is probably greater than anyone imagined and that would mean the Bank of England getting out the quantitative easing operational handbook again.