How to Trade Various Scenarios in the UK Election

 | Jun 08, 2017 | 8:00 AM EDT
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The British go to the polls again today, for the third time in as many years. This time, they vote in the snap election called by Prime Minister Theresa May in a desire to strengthen her hand for difficult Brexit negotiations.

Opinion polls indicate a victory of her Conservative party, which could strengthen its majority by as much as 72 parliamentary seats, according to an interpretation of the various opinion polls by Electoral Calculus, an independent website providing analysis of the public surveys.

That expected outcome should be reassuring for investors, but worries have been seeping into markets as May's campaign has been marred by U-turns and bad communication, while the leader of the opposition Labour Party, Jeremy Corbyn, has seen a surprising rise in public approval.

Looking at less conventional measures of public mood, Corbyn was the most searched political leader online in the U.K., taking up more than 50% of all searches in Britain in the week from May 25 to May 31, according to Captify, a search intelligence provider.

The mood of Internet searches does not paint a pretty picture for the Conservative party, as Prime Minister May doesn't seem to be very popular online. An overwhelming majority of online searches in the month of May (94%) for her name were negative, with just 6% positive. By contrast, 68.6% of searches for Corbyn were positive vs. 31.4% negative.

Still, online searches are even less of a predictor of election results than opinion polls. Anyone can search online -- school kids doing homework, writers in search of inspiration, journalists trying to find out information, and so on.

The main scenario is still a victory for the Conservatives that would give Prime Minister May a larger majority, but investors must be prepared for anything. Let's look at the main asset classes in Britain and try to predict what they likely would do under various scenarios.

Sterling

The British pound was hit hard by the Brexit vote last June and never really recovered. Don't expect it to rise to levels before the Brexit vote even if May gets a comfortable majority, because Brexit negotiations likely will be difficult for her. But most analysts believe the pound would gain some ground if she does get a bigger majority.

This belief is based on a theory that a comfortable majority for May -- of more than 50 seats, say, compared with her current majority of 17 -- would allow her to negotiate a "soft" Brexit, one in which the U.K. would keep a lot of the advantages of free trade with the European Union. A majority of less than 50 seats would be seen as a disappointment and could knock down the pound.

Analysts believe a victory by Corbyn (highly unlikely) would see the pound plummet because he is perceived as a hard-left leader. He pledged to nationalize the railways, which are plagued by delays and poor service as the private firms running various sections of the network have monopolies on them, and to raise taxes on higher earners to invest in education, welfare and health.

However, it is possible that a Corbyn victory would deliver a "softer" Brexit than a victory by May. The prime minister already has antagonized various European Union leaders with her refusal to contemplate compromises on things such as freedom of movement for EU citizens, while Corbyn has struck a conciliatory note, saying he would be open to negotiation. So, in the unlikely case that Labour gets a majority, the pound still could still gain some ground after an initial wobble.

The worst-case scenario would be a hung parliament, in which no party receives a clear majority. The pound would slump if that is the outcome, because lengthy, perhaps acrimonious talks to form a government would follow. That situation would be particularly bad because the Brexit clock is ticking, with the two-year deadline for EU withdrawal negotiations set to expire at midnight on March 29, 2019.

Equities

Usually when the pound falls the FTSE 100 rises, because the blue-chip companies that make up the index either export a lot so they benefit from a weaker currency or they receive a big part of their revenues from their operations abroad. So if the outcome does end up in a hung parliament, the FTSE 100 is the least likely asset to suffer. However, it doesn't mean FTSE stocks would do well; they probably would do less badly than the pound or small and midsize stocks.

In the case of a Conservative victory, small and midsize stocks are likely to do well, at least for the short term. These companies are in a sweet spot because they still have unfettered access to the EU market, which takes in 45% of U.K. exports, and have benefited from the weaker pound.

The highly unlikely scenario of a Labour victory would be negative for equities across the spectrum. Corbyn has said Labour would raise corporation tax to 21% for small firms and to 26% for larger ones from the current level of 19%.

Government Bonds

Gilts, as U.K. government bonds are known because the paper they used to be printed on was gilt-edged, are perhaps the less likely asset class to offer a coherent signal about the market mood. This is because the Bank of England owns more than a quarter of the public debt outstanding due to its quantitative easing program.

Still, Labour has promised big spending efforts if it wins. So, logic dictates that yields should spike as gilt prices would fall in case of a surprise Corbyn election. Yields move inversely to prices, and more issuance of government debt would depress gilt prices over the longer term.

In the short term, however, a Labour victory could depress yields and push prices up because investors would flee to the safety of government bonds. A victory by the Conservatives could send yields higher for the opposite reason -- investors would embrace riskier assets and sell gilts.

In the case of a hung parliament, gilt yields probably would fall as investors flee for safety. This situation would be temporary, however -- prolonged bickering about a future government would dent confidence in any U.K. assets. In that case, gilt prices could fall in step with equities and the pound.

Exit polls probably will be published after polls close at 10 p.m. London time (5 p.m. New York time), but it only will be at around 5 a.m. London time (midnight New York time), after key results are counted, that the winner should become apparent.

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