Three Scenarios for Financial Markets Following U.K. Elections

On May 7, 2015, the United Kingdom will hold elections that could dramatically reshape its relationship with the European Union (EU).  Currency patterns for both the Pound and Euro might be disrupted as trading relationships could be thrown into doubt.

For the moment, the elections appear as though they will be closely contested and it is difficult to privilege one outcome over another.  That said, we see three major scenarios as worth examining:

  • Conservative (Tory) Win
  • Hung Parliament
  • Labour Win

These three scenarios could produce significantly different outcomes with respect to the UK’s relationship with the European Union.  Let’s explore them one by one.

 

Scenario 1: Outright Tory Win

This scenario seemed more likely a few months ago than it does on the eve of the election, given that the Conservatives momentum has diminished and the polls show them to be in a dead-heat with Labour. That said, the Tories have a long history of outperforming opinion polls on Election Day (although not so much in 2010). One might also say that the Labour Party has a long history of snatching defeat from the jaws of victory. Either way, Prime Minister Cameron’s Conservatives could squeak out a win, even if it is not the likely case.  In order for this to happen they will probably need a last second swing of anti-EU UKIP supporters into their camp.

As previously noted, Cameron has promised that if his Conservative Party wins, he will call for a non-binding referendum as to whether the UK should remain a part of the EU.  For a long time public opinion polls indicated that if such a referendum was held, the UK public would vote in favor of leaving the EU.  The polls appear to be shifting but even the prospect of a vote to leave the EU could be a source of volatility for UK and more generally European bond, equity and currency markets. As such, a Tory win could move markets.   The Euro relative to the US dollar might also be destabilized.

There is considerable debate over the consequences of the UK leaving the EU.  Some consider that it would be a disaster for British businesses and the economy, and would reduce the UK’s influence in Europe.  However, others argue that if the UK were to leave, it might not be such a big deal. They point out that the UK could work out an agreement with the EU that resembles the one that Norway and Switzerland have with the group.  Although neither Norway nor Switzerland are members of the EU, their citizens move freely within the EU – in fact, more freely than UK citizens currently do.  Moreover, Norwegian and Swiss businesses are deeply integrated with their EU counterparts.  Finally, as the Swiss have discovered, not having joined the EU does not exempt Swiss financial institutions from the reach of regulators and tax authorities across the continent.  UK citizens, banks and other businesses might find themselves in the same boat were they to leave the EU, depending upon what sort of agreement was reached and how disruptive a transition out of the EU would be. It is also worth noting that the UK, like non-EU members Norway and Switzerland, remained outside of the common currency.

 

Scenario 2: Hung Parliament

By its very nature, this is the most difficult scenario to evaluate because it would depend on how the seats in Parliament are divided among the smaller parties.  If it is another Conservative-Lib Dem government, Cameron might or might not call a referendum regarding EU membership.  The Lib Dems do not want a referendum, and they would have considerable bargaining power. The outcome would likely resemble Scenario 1, but note that the Lib Dem’s are not likely to want to be a part of another coalition.  As has been observed in many countries, the smaller party in a coalition government often loses popularity substantially at the next election.

If a hung Parliament produces a Labour-Lib Dem or a Labour-Scottish National Party (SNP) government, the outcome would be considerably more pro-European and a referendum would be unlikely during the term of office of any such coalition.

The present coalition aside, hung Parliaments have often proved to be short-lived.  The one formed in February 1974 did not make it past October of the same year.  The Lib-Dems insisted on a full fixed-term parliament as the price for being part of the current coalition with the Tories.  The idea of a full fixed-term Parliament may be losing its appeal.  In any case, a Labour-based coalition might also spell market volatility even if the UK-EU relationship is maintained, given the policy uncertainties that would accompany such a government.

 

Scenario 3: A Labour Victory

The chances of an outright Labour majority are small.  A Labour victory with the help of some smaller parties, however, is the scenario favored by public opinion polls.  The main hindrance to a Labour victory is that the SNP is likely to take many, if not most, of their seats away in Scotland.  If Labour comes to power even with formal or informal partners, it is unlikely that it will call a referendum on EU membership.  The UK will continue to have plenty of bones to pick with the EU over matters like financial services regulation but any such dispute would likely be handled within the usual EU framework. This scenario would likely have UK equities breathe a sigh of relief in the short run but might be of little consequence in the long-run.

The UK has often had an uneasy relationship with the EU.  In 1967, French President Charles de Gaulle said “non” to the UK joining the European Economic Community (EEC), the EU’s predecessor. Even after the UK joined the EEC in 1973, relations with its European partners were not always smooth. During the 1980s, some of Thatcher’s most famous one-liners had to do with disputes between the UK and the European Community, including her famous “I want my money back” remark (referring to agricultural subsidies) and her “No, no, no” speech to Parliament (regarding the efforts to expand the EU’s powers into health care policy, national security, and the creation of a common currency).

Things have not gotten easier over the past quarter century, most especially, since the financial crisis. The UK is at a fork in the road with respect to Europe.  Whichever path voters choose, it will have plenty of short-term consequences for financial markets.  How much a decision to leave the EU matters in the long run is a subject of considerable debate that will intensify ahead of a referendum, should one occur.

For centuries, the UK’s overriding foreign policy goal has been to make sure that no one power comes to dominate the continent (see Spain in the 1500s and early 1600s, France in the late 1600s up to the 1870s, Germany from 1870 to 1945 followed by the Soviet Union until 1991).  If the UK leaves the EU, it will lose its direct leverage over decision-making in Brussels but could still pursue its divide-and-conquer strategy by setting the remaining EU members against one another on issues of interest to the UK, including financial services regulation, while still cooperating with the EU and its member states in other areas such as national security and intelligence. The EU, however, could do the same, pitting Scotland against England within the UK.  Interesting times ahead!

Blu Putnam is Chief Economist and Erik Norland is Senior Economist at CME Group.

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