A stronger Conservative majority likely to produce short-term rally for sterling, but weigh on longer term prospects. Other results may produce risk-off selling in UK assets on political instability but increased chances of a softer Brexit may boost sentiment longer term.

Sterling could go either way on Friday as the general election result remains too close to confidently predict. The polls have significantly narrowed and there is now a significant chance of a hung parliament.

The pound faces a major test. If it’s a hung parliament, the pound is likely to plunge on increased political risk and a possible delay to Brexit negotiations. If Theresa May increases her majority the pound ought to rise as part of a broader relief rally in UK assets. The possibilities for cable on the different outcomes might be as much as ten cents - $1.20-$1.30 being the broad range it’s traded in lately.

But the longer term outlook is more mixed. A hung parliament makes a softer Brexit more likely.

A Labour-led coalition would prioritise single market access in Brexit negotiations (as the manifesto promises), and deliver a fiscal (reflationary) boost that would also support sterling.

Meanwhile a stronger Tory majority likely increases the chances of a harder Brexit – ie, no single market access, as promised in the Conservative manifesto – which ought to weigh on longer term prospects for sterling and perhaps any rally might be short-lived as traders sell the bump.

Cable is up around 5% this year and there are clear signs that the rally is reaching its end as sentiment turns noticeably less bearish.

Polling remains close and unpredictable. Some surveys show a hung parliament likely, while other polls indicate a strong Conservative majority will be the result. Given how polls have got it wrong in the last two major events – the US election and Brexit itself – it would be unwise to make assumptions.

There are three likely scenarios for the election

May large majority

First, an increased majority for Theresa May is still the most likely outcome, based on the current average of all the polls. This ought to deliver a short-term boost to the pound as the market sees this as more likely to result in a smoother Brexit process, albeit a hard one. It makes a longer transition arrangement through to 2022 much more likely.

An increased majority – something in the region of 50 – would make it easier for Mrs May to push through legislation around Brexit and get her way. This decreases the risks of domestic political instability, which all things being equal should be supportive of the pound. It limits the chances of a cliff-edge exit from the EU but does mean growth is likely to slow as trade barriers, tariffs and the loss of passporting rights affects the economy.

However, a stronger Tory majority makes a hard Brexit (no single market access, no passporting rights for financial services, etc), more likely. Therefore sterling may find it hard to sustain gains resulting from the initial market reaction. Positioning in sterling is not as short as previously - net shorts for GBP around a quarter of what they were in April, before the election was called. This suggests the pound’s rally may be running out of steam.

Longer-term growth prospects diminish in tandem with the prospects of a harder Brexit. Therefore the upside to sterling may be capped, particularly as it should ensure the Bank of England keeps interest rates on hold at current record low levels given the chance of weaker inflationary pressures and growth.

A pound rally is now less likely to equate to a fall in the FTSE despite that trend being seen since the referendum. Indeed the correlation between the FTSE and Sterling has come back after suffering a traumatic breakup following the June referendum. The FTSE and GBPUSD are both up in the region of 5% this year. UK stocks are benefiting from a global cyclical rebound and still look relatively cheap despite the post-referendum rally, when looked at from a historic p/e ratio.

May small majority

 

A reduced majority for Mrs May is a significant risk for the markets. It is arguably the most complex scenario to predict as it raises political instability at home, while a harder Brexit is still the most likely outcome given the Conservative emphasis on this in the manifesto.

Quite what a small majority looks like is up for debate. But anything under 30 would make life very tough for Mrs May. 30-50 looks manageable but less than ideal, while anything beyond 50 sees the prime minister breathing a little easier. Beyond 80 makes her look unassailable. Under 30 and not only will Mrs May find it tough to pass legislation, but questions are going to be asked about her leadership.

Indeed, arguably the biggest risk around this result would be the departure of Mrs May if the Tory party (especially the Brexit wing) decides she’s failed in securing a personal mandate to take the country out of the EU.

 

Hung Parliament

A hung parliament has the potential to significantly alter market positioning.

With the Tories finding it hard to secure partners if they don’t have more at least 300 MPs, it could easily result in a Corbyn-led coalition. This might spark an immediate sell-off in UK assets, including the pound and equities, with investors reacting gingerly to the uncertainty and potential shift in the domestic policy landscape – tighter labour laws, nationalisation, and higher personal and corporate taxes.

It would dramatically increase political instability and could delay Brexit negotiations from taking place. A coalition of Lab/Lib/SNP and others, however loose, would need to agree some kind of approach to Brexit and this could take a long time, leaving sterling vulnerable in the meantime.

Defensive stocks and gilts could benefit from a flight to safety.

However, ultimately we could see a significant fiscal boost as Labour plans to open the spending taps, which could produce a reflationary environment that underpins sterling strength as rates and yields rise in response.

It could also result in a much softer Brexit – protection of passporting rights for financial services, single market access – that would naturally lead to a realigning of the sterling exchange rate towards recent historic averages.

A major tail risk from a Corbyn coalition would be a second referendum on Scottish independence, which might be the pound of flesh extracted by the SNP in return for votes.

 

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