NEWS Trends

Hermes responds to the UK General Election results

With hindsight, the decision of Prime Minister May to hold a snap election backfired spectacularly.

A populist surge, similar to what we saw in the UK Referendum or the US and French elections, saw voters respond to Mr McDonnell’s economic policies, and to Mr Corbyn’s authenticity. This combined with growing doubt about Prime Minister May’s leadership, particularly since she was starting to be blamed for not doing enough to deter the terrorist atrocities in Manchester and London, delivered one of the most unexpected results in UK Parliamentary elections in decades. Markets abhor both the unexpected and uncertain.

The expected reaction is for both sterling to come down and possibly the FTSE, notwithstanding sterling’s fall. We are likely to also see forward markets discounting rises in interest rates which will adversely impact the consumer in the short term as mortgage rates could start to rise further and faster than most borrowers budgeted for.

Neil Williams, Group Chief Economist
Equities and the pound may be the obvious pressure release if perceptions now build of policy confusion, ‘bigger government’, corporation-tax rises, and a yet wider budget deficit. And, once the dust settles, reality will set back in as Brexit negotiations are supposed to take centre stage from 19 June. The Brexit road was always going to be long, but a hung parliament puts in place an additional speed bump.

Buckling up for a long journey...
Prime Minister May’s call to bring forward the election to 8 June was not just a way of consolidating her political position, which has failed. It was also tacit recognition that Brexit negotiations will take much longer than the two years hoped for by triggering Article 50. In theory, getting the election out the way, instead of waiting until May 2020, offers the new administration an extra two years to strike a deal before having to go to the nation again.

However, even this may not be enough, with the biggest question still about the length of the journey ahead. I fear our negotiations could take many years, and could potentially end up back close to square one in terms of striking the free trade agreement that both the Conservatives and Mr Corbyn want. This suggests they will negotiate to maintain access to, but no longer full membership of, a tariff-free system akin to Canada’s deal, and/or a customs union similar to Turkey’s.

Even this will need time. First, when the deal is struck it will need Parliamentary approval, and then probably still be subject to a ‘phasing in’ period to allow firms, consumers and officials to adjust to the new arrangements. If the parties cannot agree, the possibility of yet another, earlier election would be an unwelcome complication.

Second, the UK is relying on a cooperative sign-off by its 27 EU peers. The only real precedent we have is Greenland’s ‘exit’ in 1985. This was a ‘soft’ exit, but it took three years. The UK, being significantly larger and 44 years entwined in the EU, will need longer.

We are opening the ‘trapdoor’ in a highly charged political year. Some voters still to face national elections in Germany and probably Italy may want to approach it as protest to six years of euro-zone austerity. In the ‘peripheral’ economies, reform fatigue and populist parties are building. Therefore, incumbents may be reluctant to condone an easy UK exit that puts its economy ahead of their own.

Meanwhile, EU law forbids trade-deal ‘bigamy’, in terms of enacting agreements elsewhere while still an EU member. For example, this prevents a quick compensating tie-up with the US. Thus, a challenge for any new coalition is to remain close enough to the European negotiating table to maintain the best trade and regulatory deals for services, which account for 80% of the UK’s gross value added. This makes it more ambitious than a Canada-style deal.

This leaves the BoE watchful that a weaker pound does not pump inflation, especially with the main activity data having held up since last June’s referendum. Should protectionist forces build, inflation will reappear, but it will be the ‘wrong sort’ – cost-push, led by tariffs, goods and labour shortages, rather than ‘feel-good’ demand-pull. This portends more to the inflation rises of the early 1980s and 1990s UK recessions, than the overheating of the late 1980s and mid-2000s. In which case, the inflationary flame may snuff itself out without BoE action.

Consequently, we may still have to compromise if we want tariff-free trade – after all, this is our second European ‘divorce’, after that from the European Exchange Rate Mechanism in 1992. Therefore, any tie-ups in the future – with Europe or elsewhere – will doubtless come ‘with strings’. A bit like EU membership then!

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