#MacroMemo: British Election Special Report

Mayday, Mayday – British election crash-landing - Summary

• British Prime Minister Theresa May’s election gamble has failed spectacularly, delivering only a Conservative minority and a boatload of questions about the future.
• This is merely the latest in a remarkable sequence of ill-advised elections/referendums initiated by Conservative prime ministers, resulting in surprising and undesired outcomes.
• At this juncture, May appears intent on staying on as prime minister, and enlisting Northern Ireland’s Democratic Unionist Party (DUP) to secure the necessary confidence votes.
• Although the level of British uncertainty is again ratcheted higher, the most likely scenario is a slightly softer Brexit and somewhat more expansive fiscal policy – both reasonably positive economic outcomes over the short- and medium-term.

Why was an election called?

• The election sequence was triggered on April 18th by British PM Theresa May in the hopes of translating a large 20ppt-plus lead in the polls into an even larger parliamentary majority, anointing the prime minister with “elected” rather than “appointed” status, and buying several additional years of Brexit negotiating time.
• In actuality, almost precisely the opposite series of events has transpired. The Conservatives have lost their majority, succumbing to minority status. In so doing, the prime minister has been rebuked by the electorate. And the history of minority governments suggests there will be less time and a less coordinated approach for Brexit negotiations.

Why did the Conservatives fare so poorly?

• Mathematically, it was clear that the vote was getting tighter with each passing day. Two months ago, the Conservatives enjoyed a 20 percentage point lead. Two weeks ago it was just 10 points. At the start of this week, it was down to roughly 5 points. Momentum showed a distinctly surging Labour party and a fading Conservative one.
• In terms of the underlying reasons for this shift, there are several theories.
• It is certainly fair to lump this result into the growing list of elections that have tilted in a populist or anti-establishment direction around the world. In the U.K. context, the Conservatives are the establishment and Jeremy Corbyn’s Labour party represents a brand of left-leaning populism.
• Some are interpreting this election as anti-Brexit response. The “hard Brexit” Conservatives were rejected in favour of the “soft Brexit” Labour party.
• The tragic terrorist attacks on British soil in recent weeks, while superficially a benefit to Conservative prospects given their anti-immigration stance and hardline response, may have instead hurt the party given May’s prior role as Home Secretary where she had presided over a shrinking police budget.
• Finally, the Conservatives arguably ran a weak campaign while Labour cleverly de-emphasized the Brexit headache and their far-left inclinations, instead focusing on economic issues of relevance to the average person.

Voting math with a surprising twist:

• In the end, the Conservatives managed to eke out a 1.3ppt lead in the final vote share, translating into around 319 seats. This is just short of the 326 needed to form a majority government and the 331 seats the party held prior to the election.
• The only real winner among the major parties was Labour, which added 29 seats to alight upon a total of 261.
• As expected, the Liberal Democrats remained largely sidelined with just 13 seats, independence-oriented UKIP were entirely wiped out now that their reason for existing (Brexit) is underway and the Scottish National Party lost a whopping 21 seats to land at just 35 remaining.
• There are two underlying narratives in these figures. First, voters consolidated around the two biggest parties (Conservative and Labour) to an unusual degree. Second, Labour performed very well.
• It is remarkable to discover that the Conservative’s 42.4% support was their highest share of the vote in thirty years, as good as Margaret Thatcher ever managed and only beaten when one ventures all the way back to the musty early 1970s.
• It is just that there were fewer small parties to break up the Labour vote, with Labour instead capturing a big 40.1% of the vote for itself, its highest tally in sixteen years and better even than the Tony Blair majority win of 2005.

Likely government is Conservative minority with DUP support:

• The Conservatives have said that they will partner with the DUP, a right-leaning party based out of Northern Ireland that managed to capture 10 seats. Their combined forces secure the bare majority necessary to govern.
• The DUP leans to the right and is thus a natural ally for the Conservatives, though its views are not identical. It favours Brexit, but arguably a softer version that might allow for a single market and an open border with Ireland. Its fiscal views are somewhat more expansive while its social views are more conservative. DUP now stands to punch well above its weight in helping to form British public policy.
• The two parties are unlikely to create a formal coalition, but rather should operate under a loose sort of alliance. This is in part because the DUP is arguably too small a party and too geographically concentrated to manage the what the Conservatives did with the Lib Dems two elections ago (recall that included sharing cabinet positions), and also because the Lib Dems did so poorly in the subsequent election that no other party would want to repeat the experience.
• So far, Prime Minister May seems intent on bulling ahead with her prior plans for Brexit and public policy more generally. This attitude will likely have to change significantly.
• The first set of tests will be on June 19th, with the Queen’s Speech (an event requiring a confidence vote that could pull down the young government) and the official beginning of Brexit negotiations.

Alternative scenarios include another election:

What other political permutations are possible from this election?

• One scenario is that Prime Minister May could opt to resign given the failed election, providing another Conservative with an opportunity to make things work. There was much speculation to this effect in the immediate aftermath of the election, though the idea seems to have cooled for the moment. It could yet rear its head over the next few days or weeks. Even the DUP head Arlene Foster was quoted as saying it would be “difficult” for May to remain Prime Minister for long.
• Labour’s Corbyn says he will try to form a government, though this seems unlikely on two counts. First, the party with the most seats gets the first stab, and May has already met with the Queen. Second, Labour plus the Scottish National Party plus the Liberal Democrats still leaves a seat count short of the Conservatives, and short of a majority. At least five parties would have to unite to unseat the Conservatives, and that seems extremely unlikely.
• The most likely alternative is a second snap election if the tentative government loses a confidence vote. This next election would be held in a few months. It is hard to say how the seat count would differ in such an event.

“Softer” Brexit implications:

There are two main implications for Brexit. The first is that the level of uncertainty has ratcheted higher. The second is that, on average, one should expect Brexit to be a bit softer than before. There are four scenarios to consider.

• No Brexit: The prospect of avoiding Brexit altogether is not high, but has arguably risen. There has always been a non-trivial possibility that Brexit would be avoided altogether, either because the U.K. or Europe thought the better of it. It is possible to argue that this election was a belated rejection of Brexit by British voters. Even if not, the reality of an unstable minority government could yet unleash further elections and more opportunities for the U.K. to back out of Brexit.
• Soft Brexit: A soft Brexit may now be the most likely scenario. This means that the official exit proceeds, but while still allowing something like a single market and/or borders that are not completely closed to the flow of European workers. Supporting this notion, both the Labour party and the DUP support a soft Brexit. The latter is focused on ensuring an open Ireland-Northern Ireland border.
• Hard Brexit: This is arguably less likely because it was mainly supported by the Conservative party that has now stumbled.
• Very Hard Brexit: Here is where the story takes a turn. Although a hard Brexit is less likely, a very hard Brexit is arguably more likely. This is because a minority government will make it difficult to negotiate coherently for any period of time. It will also make it harder to pass difficult legislation that may be needed to formalize an exit. As such, the possibility of the U.K. simply dropping out without a deal has gone up. Thus, while a softer Brexit is more likely on average, the risk of a worst-case scenario has also risen.

Fiscal implications net positive:

• We expect more fiscal support for the British economy over the next few years since most parties, including both Labour and the DUP, are inclined in this direction. Their voices now matter in a minority government.
• For that matter, regardless of the parties involved, minority governments are often quite spendthrift since they must appease multiple interests at once and because they tend to have a myopic perspective (due to their short life span) that puts debt concerns in the back seat.

Economic consequences surprisingly benign:

• While higher political uncertainty is a clear theoretical negative, markets and economic actors have not generally paid it much heed in recent years. For now, we assume this doesn’t matter much, though it should.
• In the short run, the U.K. economy could grow a bit more quickly under the current arrangement thanks to additional fiscal stimulus as per the prior section.
• Then, over the medium run, a softer Brexit would result in less of an economic drag than otherwise (though there are huge error bars around this assertion).
• A further positive – arguably spanning the political and the economic – is that this election reveals a materially reduced appetite for Scottish separation. The Scottish National Party lost quite a large number of seats and their leader has hinted that another referendum is now off the table for now.

Market implications also benign:

• The market implications of this surprise election are also fairly benign, as the negative (significantly greater political volatility to come in the U.K.) is seemingly offset by the positive (more fiscal stimulus, softer Brexit).
• As such, it is unsurprising that various market instruments have been split in their interpretation.
• The pound is down moderately and government yields are down slightly whereas the British stock market has managed to rally.
• But the main point is that markets have barely reacted, and this seems like the right interpretation.

Global implications fairly small:

Finally, the global implications are fairly limited, as reflected in unperturbed global financial markets. At the margin, the following thoughts may be relevant:

• A slightly softer Brexit is good from a global growth perspective, as is the possible U.K. shift toward more fiscal stimulus.
• Populist/anti-establishment forces are still a force to be reckoned with, despite a string of favorable elections in continental Europe.
• Global uncertainty has risen slightly.

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Data run:

• Fed preview: The Fed’s long-awaited June decision beckons in the coming week. There, markets assign a 90% likelihood to another 25bps rate hike. This would be the second rate increase this year. This expectations seems about right given recent Fed statements and the reasonable health of the U.S. economy. We would budget for a “dovish” hike, however, as the Fed may be wary about over-promising future actions given a bit less economic strength relative to earlier in the year, slightly lower inflation and the absence of long-awaited fiscal stimulus. There is also an ongoing debate internally about the appropriate timing and pace of any effort to shrink the central bank’s balance sheet. This is unlikely to be resolved at the June meeting.
• ECB review: The ECB’s latest decision tilted in a more hawkish direction in a variety of important ways, such as by removing an easing bias from the level of the policy rate and upgrading growth forecasts slightly. However, these developments were widely expected, whereas the more dovish elements of the decision were less fully priced in. On this front, the ECB maintained its easing bias with regard to quantitative easing operations – potentially delaying the next step down in the pace of bond buying – and the inflation outlook was downgraded more sharply than expected. Thus, markets reacted in a dovish fashion. Unlike the Fed, the ECB is in no rush to disentangle itself from the era of extreme stimulus.
• Canadian employment: After stutter-stepping in April, Canadian employment again found its stride in May. A big 54K increase in employment was underpinned by an even stronger rise in full-time jobs (+77K) and a solid gain in private-sector jobs. Wage growth – long bad but incredibly awful in April – has at least started to inch higher, with a meagre 1.3% YoY gain in May. The unemployment rate edged higher due to additional job seekers, but remains decent by Canadian standards at 6.6%. Really, the only thing to complain about was the aggregate hours worked, which were down slightly. Overall, we view this as a very strong report and one that continues to point to a Canadian economy hustling along.

Political wrap:

• Beyond the U.K., a few other political developments are salient.
• The Spanish region of Catalonia has increased long-running tensions by calling a (technically illegal, according to the Spanish constitution) sovereignty referendum for October 1st. This may yet be blocked by the Spanish government.
• In the U.S., former FBI director James Comey has testified to the Senate about his interactions with President Trump in the context of allegations of Russian interference. Not much new came to light, and the information that did was arguably favorable toward Trump. One such item was that – as of the date of Comey’s departure – the FBI was not formally investigating Trump. Another was that Trump said that he wanted the FBI to find out if anyone on his staff had acted illegally. Accordingly, the risk of Trump impeachment has arguably fallen somewhat. Of course, Comey also testified in secret and we cannot know what was said in that forum.

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