British Pound's Surge on Snap Election Hopes May Be Temporary

 | Apr 19, 2017 | 9:00 AM EDT
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Oh, God, not again.

That was the reaction of a lot of people whom British politicians like to lump together under the generic term "the British public" to Prime Minister Theresa May's announcement that a snap election will take place on June 8.

The markets, however, seem to like the idea -- at least judging by the performance of the British pound. It jumped to a six-month high versus the dollar on Tuesday after the announcement. The FTSE 100, which moves almost in the opposite direction because many of the companies in it have revenues in dollars, fell by 2.5%, the most since the June 23, 2016, Brexit vote.

A belief that a snap election equals a "soft" Brexit is behind the pound's surge. But that belief could turn out to be very wrong.

Analysts at Deutsche Bank said the snap election announcement made them revisit their bearish bets on the pound. In a widely quoted commentary, the analysts said the election "is in our view a game-changer for both the U.K.'s Brexit negotiations and sterling."

They do not see the election as a mandate for a "hard" Brexit, where the U.K. leaves the European Union without much in terms of a free trade deal. Instead, they believe it could result in a more stable Conservative majority that would bring a "soft" Brexit, with a lot of compromise on both sides.

Brian Hilliard, a U.K. analyst with Societe Generale, concurs. For Prime Minister May, one of the attractions of an early election will be to dilute the influence of the hard Brexit camp in her own party, he said.

The logic behind this thinking is that May's Conservative Party has a small majority of just 11 seats right now. This makes it easy for euro skeptics in her party to push for a "hard" Brexit rather than compromise on many issues to ensure a smooth deal with the European Union.

"She has a commanding lead in the opinion polls, which has clearly emboldened her to lance the boil to give herself the negotiating room for maneuver on Brexit that she needs," Hilliard said.

However, investors may be ignoring two major obstacles to a positive "soft" Brexit scenario. The first is May herself. So far, she has changed her mind on almost all the important issues that confronted her, showing that she can be pushed around and she doesn't know herself what she wants.

First a Remainer, May turned into a fervent supporter of Brexit after she became Prime Minister last July. After initially allowing her Chancellor of the Exchequer, Philip Hammond, to increase National Insurance contributions for the self-employed in his Spring budget last month, she then said the measure would be delayed until this autumn.

And now, with this snap election decision, May has performed another big U-turn. In September last year she said she wanted the current parliament to run its full mandate, which expires in 2020. One of her arguments in favor of changing her mind now is that EU politicians, knowing that she would face an election soon after the U.K. is set to leave the EU, would put pressure on her.

But this was the case all along, so that argument doesn't stand up to scrutiny. The same goes for her claim that the opposition is trying to throw a spanner in the Brexit works. So far, proceedings in Parliament have been remarkably smooth; even pro-European lawmakers voted last month to allow her to start the withdrawal from the EU.

May's own indecision and lack of transparency about her motives make up the main hurdles to ensuring an orderly negotiation period. They enhance already existing uncertainty and risk increasing the distrust of her negotiation partners.

And this is how we come to the second big obstacle to a "soft" Brexit: the EU negotiators themselves. The pragmatic thing would be for the Europeans to try to reach a deal that involves a minimum of disruption for both sides. For instance, allow U.K. banks to keep their "passporting" rights, or impose minimum restrictions on trade, or ensure that U.K. universities still have access to wider EU research exchange programs.

But I am afraid the Europeans will not be pragmatic. The Brexit vote opened Pandora's box for the EU and forced it to stare into the abyss of its own implosion. Whether it will survive is still a matter of debate, although judging by the Dutch election Brexit also seems to have emboldened the moderates to go out and defend the EU. But it is clear that after what they've been put through, the Europeans will play tough in the negotiations.

For investors, May's decision to call early elections increases the uncertainty rather than curtails it. The pound's surge may be temporary. As for the stock market, the most at-risk sectors are the financials, which are set to suffer if they lose their right to sell their services in the EU, and consumer discretionary stocks, as British consumers are starting to shut their wallets. Expect at least some hardship ahead.

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