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Open and Free

Brexit is the key issue for the British election. The UK is leaving the European Union but the terms of divorce are still to be argued over.

The importance of the election is that it delivers a British government with a strong enough mandate to fight for a deal that secures the best possible relationship with the European Union (EU) and is consistent with British historical preferences for free-trade and openness. For markets, an outcome that does not deliver a strong government would be negative and this would be seen mostly in renewed sterling weakness. For bonds, the Bank of England (BoE) is sitting tight. Parts of the economy are doing better than expected but consumers are struggling with a decline in real incomes. Gilt yields remain low and will only likely go up if global yields do or if internal political risks escalate. For the short term the UK election is important but the most likely outcome should not ruffle markets.

Left – right
On one level the upcoming general election in the United Kingdom is a straight fight between the Labour Party and the Conservatives, as is always the case. Voters that want more government intervention in the economy and increased spending on public services funded by higher taxes will tend to vote for Labour. Those that favour a more market oriented approach to government with tighter controls on public spending to allow a reduction in the tax burden over time will tend to vote Conservative. However, this time there are two important other themes. The first is that the current leadership of the Labour Party is more left-wing than for a very long time and, history suggests, that the majority of UK voters tend to reject more socialist policy agendas. This appears to be reflected in both opinion polls and in the early results from local authority elections on May 4th. The second theme that makes the election different to a straight left-right contest is Brexit. The over-arching influence of Brexit on the political debate and the positioning of each of the major parties means that it is difficult to read exactly how votes will be cast given that the split between “Remain” and “Leave” does not follow party lines. One will find both “Leave” and “Remain” voters that traditionally vote Conservative and the same for Labour. Only with the Liberal Democrats, the third party in the British parliament, is there more of an alignment as it is explicitly a party that was against leaving the EU and is electioneering on the single policy of ensuring that Britain gets a deal that is pretty much to secure the status quo in terms of the relationship with the EU.

Brexit is the key issue
The consensus view in the media is that the Conservative Party will increase its majority in the House of Commons and that this will give the Prime Minister, Theresa May, a stronger position in terms of negotiating with the EU on issues like access to the Single Market, immigration, financial services and the rights of both EU citizens that live and work in the UK and British citizens that work and live in the EU. The view is that the larger the majority for Mrs. May, the better the chance she has of securing a “soft-Brexit” as the hard-liners in her party will be outnumbered by those that want a “good deal” for Britain. That seems an outcome that would sit most comfortably with financial markets as it would leave open the possibility that, over time, trade relations with European countries would not be disturbed too much, that there would not be major restrictions on the ability of people to live and work in the UK and vice versa and that the important financial services sector in the UK would continue to play an important pan-European role. If Emmanuel Macron wins the second round of the French election this weekend and if Angela Merkel is re-elected as Chancellor of Germany in the autumn, then my view is that one can see the possibility of a more benign divorce with a commensurate push to reform the EU and allow the current cyclical upswing to continue. This might be seen as the “win-win” scenario.

Open or closed, what will Britain look like?
I recently read a book called “Prisoners of Geography” by Tim Marhsall. It’s a study of geo-political issues with the consistent theme that, through history, physical geography has played – and continues to play – a major role in determining the shape and outcome of geo-political issues. There’s an important chapter on Russia which discusses the role that physical geography has played in determining Russian foreign policy – the search for a warm water naval port, the importance of the great Russian plain that stretches from Moscow to the borders of western Europe in making it very hard to invade Russia. For the US it describes the effect of having a large navigable river basin – the Mississippi – in the centre of the continent that allowed for the easy transport of goods as the US expanded westwards from the original colonies on the east coast. Having read the chapter on the UK it helped me to think more about Britain’s role in the world and particularly its current relations with the EU. Britain is an island nation and that has shaped its political history. It has always been an outward looking, trading focused nation that has generally been open to immigration and able to assimilate different cultures and nationalities. Its island status meant it developed a strong maritime tradition, both commercial and military, and its wealth has been built on trading with the rest of the world. How does this fit with the decision to leave the EU? It is clearly complicated but in my view it is because the EU changed over the course of the period of UK membership. The original decision to join was motivated by the opportunity to trade with a large market that was becoming wealthier following the difficult two decades after the second world war. On the whole, it has been a hugely beneficial experience given the strength of Britain’s trading links with the rest of Europe and the social and economic integration that has been achieved. An experience in keeping with the history of the UK as a trading focused economy. The problem has been politics. Britain’s have a tendency toward free market capitalism, open trade and, importantly, sovereignty. Over time the EU has been seen to become less democratic, more bureaucratic, more federalist and structurally less dynamic. This coalesced in to a visceral reaction in the UK last June where the focus of the referendum became too much immigration, too much loss of sovereignty over domestic law and too little value for money for the UK which has always been a large contributor to the EU budget. The “Leave” campaign was able to leverage on these, often prejudicial views, and argue that they were inconsistent with the British values of free trade and democratic market capitalism. It is not random that the pro-leave campaign have since stressed that Britain will be better served outside of the EU and re-balancing its trade towards the rest of the world, as it has done in the past.

All about the deal
This makes me think on one level that a post-Brexit Britain will be an open economy with a strong free-trade ethos and will continue to be a welcoming destination for foreign capital and foreign skills. However, the problem at the moment is not the arriving, but the travelling and this is where the election is interesting. Even if the Conservatives win with an enhanced majority, it is not clear how the negotiations with the EU will evolve in the next 2-years and the recent spats between the British government and the European President do not bode well. There seems little chance of a Labour victory in the election, according to the opinion polls, so it is likely that the British position will be one that serves those historical preferences for trade and openness, but just how the European side responds to that remains to be seen. For example, if no agreement on the “passporting” of financial services is reached then an acceleration of banking and related jobs being moved out of the UK to other locations in the EU is likely. In a longer term context, an election that delivers a government that can focus on traditional British preferences, even if it will be a difficult period, is the one that is the best outcome for the economy and markets. What is important for the UK economy and for financial markets over time is just what the economic implications of the exit deal will be. The risk is of reduced investment spending in the UK economy, of job losses and weaker growth. That could play out in renewed sterling weakness, especially if the BoE has to return to quantitative easing (QE). At any rate, interest rates are not likely to go up anytime soon as the BoE will be concerned about the risks to the economy during the negotiating period. There may be more interesting stories in the near term at the micro level, especially if firms leave the UK or others decide to enter the UK with the view that it may be a more favorable location for investment in the longer-term from a tax and regulatory perspective. But at the macro level it is hard to have a high conviction view right now. We can probably rule out any kind of UK boom, aggressive monetary tightening and a much stronger sterling but the central case of slowish growth and political uncertainty is likely to make it hard betting on big moves on UK assets.

Internal risks
For markets then I think it is the election itself that is important in clarifying the starting point for the divorce. Is there a risk to the consensus outcome? Britain had is populist moment last June when a majority of voters, albeit a slim one, rejected membership of the EU. The first-past-the-post electoral system means it is very difficult for fringe parties to gain a foothold in parliament so, unlike in France and other European countries, we are not likely to see a fragmentation of political parties along the traditional left-right spectrum. Perhaps the biggest threat to UK finances and the stability of markets is an internal rather external story. The attempt to hold a second referendum on Scottish independence and questions around the long-term relationship between Northern Ireland and the Republic do pose a non-trivial risk to the stability of the United Kingdom. A sovereign break-up would raise lots of issues, not the least being how sovereign liabilities would be proportioned and what currency the debts of an independent Scotland would be in. The political and economic instability caused by a break-up of the Union would hit sterling and would raise questions over credit ratings for the constituent borrowers. However, these are tail-risks at the moment and, for the short term at least, the UK equity market is likely to continue to benefit from the strength of the global economy and the surprising resilience of British corporate confidence while gilts will range-trade and follow the lead of the US Treasury market, which probably means slightly higher yields over the next few months.

Chris Iggo - Chief Investment Officer, Fixed Income - AXA Investment Managers