Following the U.K.'s general election, a hung parliament renders the country's politics—and economy and markets—into a veritable choose-your-own-adventure book.
What will the next government look like?
As the largest party, the Conservatives will be given first dibs on forming a government. As this writing, the Conservatives and the Northern Ireland Unionists, or Democratic Unionist Party (DUP), had a combined 328 seats in parliament—just two seats more than the requisite 326 for a majority.1 It's possible the two parties could garner additional support from other parties to form a slim majority, but much more likely is a minority government with either a formal Conservative-DUP coalition or an informal partnership.
This minority government would require the support of opposition parties to pass pieces of the domestic preparation legislation for Brexit, complicating an already difficult negotiation process. A minority government would also be fairly unstable, and as a result, the probability of early elections is higher. We believe a collaboration between the Conservatives and the DUP would probably continue to pursue a hard Brexit—in which the United Kingdom would leave Europe's Single Market—particularly given that the DUP is closely aligned with the right-wing section of the Conservative party in favor of Brexit. But if the U.K. government had no real mandate to negotiate a hard Brexit before, it has even less of one now, and this would significantly weaken the United Kingdom's hand in the Brexit negotiations.
The leader of the Labour party has already called for Theresa May to step down as prime minister. The pressure on her to step down will be immense, even though she has vowed to carry on in the role. If Mrs. May does cave to pressure to leave, it is difficult to guess who would replace her as party leader and prime minister. Former Mayor of London and hard Brexiteer Boris Johnson, Chancellor of the Exchequer Philip Hammond or Home Secretary Amber Rudd seem potential candidates. Regardless of who may replace Mrs. May, having ‘the face of Brexit' change could shift the United Kingdom's interaction with the European Union (EU) in Brexit negotiations—and potentially in a positive way.
If the Conservative party cannot form a government—with either a majority in parliament or a minority government—the baton will be passed on to the Labour party. We think this is an unlikely scenario, but it is far from an impossibility. So far, the Labour party has indicated that if given the chance, it would opt to form a minority government rather than attempt to form a formal coalition with the Liberal Democrats (Lib Dems) and the Scottish Nationalist Party (SNP). However, we wouldn't rule anything out. Such a coalition would hold 308 seats in Parliament, short of the 326 required for a majority.2 Once again, a minority coalition would complicate the Brexit negotiations and would increase political instability.
But even at a theoretical level, there are already challenges. Labour campaigned in favor of a soft Brexit—remaining in Europe's Single Market—though this seems difficult to achieve in reality. Labour party leader Jeremy Corbyn has indicated that the party feels strongly about the United Kingdom controlling its borders. Given that the EU has been clear that no country can pick and choose which of the four freedoms it wants to embrace as a Single Market participant, either Labour will have to accept the free movement of labor or it will have to pursue a hard Brexit. The Lib Dems campaigned on the United Kingdom remaining in the EU, so Labour may have to accept free movement of labor to appease its potential governing partner.
In addition, a Labour-Lib Dem-SNP coalition would first need to devise a Brexit negotiating strategy and staff its negotiating teams. This would no doubt delay the Brexit negotiations, which are currently due to start in Brussels in just over a week. This government would also be a completely unknown quantity when it comes to its negotiating partners in other European capitals. But this needn't be a bad thing—it seems likely that Labour leader Jeremy Corbyn could go into Brexit negotiations with a more conciliatory tone than Mrs. May, whose approach has been described by some as being akin to a “bull in a China shop.” In our view, this could shift how the EU approaches the negotiations, which in many ways is far more important than what the United Kingdom's strategy is. It could also reduce the chances of the United Kingdom stumbling out of the EU with no agreement at the end of the two-year negotiating period.
If neither the Tories nor Labour manages to form a government, a new election will be called. The trouble with this is that there is little reason to believe the result would be much different. A second election would mainly just waste precious Brexit negotiating time.
What this development means for the markets
It's hard to think of a scenario in which the British pound doesn't weaken further relative to the U.S. dollar. There will be some uncertainty while a government is formed, which could prompt more pound weakness. In our view, the pound is likely to fall further if the Conservative party proceeds with plans to form a minority government and likely pursues a hard Brexit.
If Labour leads a government, there will be an even longer period of uncertainty as the new coalition works out its Brexit negotiating strategy. It is possible investors will be more bullish on the pound on the assumption that a Labour-led government can pursue a soft Brexit. However, a soft Brexit seems unlikely given that Labour would like to limit the free movement of labor. However, there could be some opportunity for the pound to recover later if a Labour government proves to be more constructive in negotiations with the EU, and the chance that the United Kingdom stumbles out of the EU with no deal diminishes.
Still, this U.K. election was not a global event: It seems likely that the impact of the election results on other markets may be muted. U.K. government bond yields are based primarily on interest-rate expectations. They may rise modestly to reflect a risk premium, but the operative word here is modestly. We also expect a further divergence in the stock prices of internally versus externally facing U.K. companies.
2 Washingtonpost.com, 6/8/17.
Foreign investing, especially in emerging markets, has additional risks, such as currency and market volatility and political and social instability.