Pray There Isn't Another Snap U.K. Election; It Would Sink the Pound and Gilts

 | Jul 27, 2017 | 8:00 AM EDT
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Amid a slew of earnings reports, the Federal Reserve's latest announcement and various updates in the seemingly never-ending White House "Russiagate" saga, investors probably have overlooked yet another blow to U.K. Prime Minister Theresa May.

Her chief of strategy, Chris Wilkins, announced his resignation, according to Bloomberg. It is just the latest in a series of resignations by her aides, which can be seen as a sign of loss of confidence in her future as Prime Minister.

While many people believe another snap election after last month's disastrous one will not happen, the reality is political uncertainty is so high that anything is possible. Infighting in the Tory party is on the rise while Brexit negotiations look amateurish at best, with senior U.K. officials unable to present a united front.

Under normal circumstances, early elections would follow if the current turbulence continued. But the alternative to the Tory party looks even worse for the pound and U.K. government bonds than the current fudge.

The leader of the Labour party, Jeremy Corbyn, has risen out of nowhere to fire up the imagination of young people in Britain disillusioned by the Brexit vote. At the famous Glastonbury summer music festival in June, the crowd attending his speech was as big as the masses the Rolling Stones attracted in 2013. "Jeremania" officially had taken over.

That is a strange position for those who support remaining in the European Union. Corbyn himself is no fan of the EU and the Labour party's campaign to remain in the EU last year before the referendum was timid at best. Recently, Corbyn blamed Central and Eastern European workers for "destroying" working conditions in the U.K.

"There would be European workers working in Britain and British workers working in Europe [after Brexit] as there are at the moment. What there wouldn't be is the wholesale importation of underpaid workers from central Europe in order to destroy conditions, particularly in the construction industry," he told a BBC program recently.

With the Tories in disarray and his rhetoric increasingly tailored to appeal to the anti-immigration segments of society, Corbyn has a real chance of getting to power if there are new snap elections. If he does, it would be really bad news for the pound and U.K. government bonds, also known as gilts.

Despite its declared austerity policy, the U.K. government already spends a lot. There is the welfare bill -- topping up low wages while company bosses get tens of millions of pounds in compensation, and paying housing benefits to tenants who cannot afford market rents in what ultimately amounts to a subsidy to landlords.

On top of the existing spending commitments, the government will have to find ways to support the industries that benefited from EU funds once it leaves the Union. It also must spend money to ensure other industries do not suffer if the departure means getting slapped with tariffs to sell their products to the EU.

With a Tory government in power, spending already looks stretched. In time, these expenditures will put upward pressure on gilt yields. The government will need to borrow more, increasing the supply of bonds and lowering their prices, which move inversely to yields.

Corbyn's spending plans have done more than raise eyebrows. Some critics have called them "outlandish." He has pledged to re-nationalize railways, energy-sector companies and Royal Mail. If a Corbyn government wants to buy back these companies, it will need to find billions of pounds, which it most likely would need to borrow.

Besides nationalization pledges, the Labour manifesto for the June 8 election was full of spending promises: interest-free loans for homeowners to help them improve their properties, £250 billion ($327 billion) of investment in infrastructure, energy and communications in partnership with the private sector, free school meals for all primary school pupils, and the abolition of university tuition fees.

The party said these expenditures would be financed by higher taxes, but the problem is that Brexit will weaken the U.K. economy and the tax take inevitably will fall. Government borrowing will need to increase. If Corbyn gets to power, bondholders might ask for higher premiums to deal with the risk caused by his high spending plans. Gilt and pound investors, be warned.

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