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Hung by the Polls: Mayhem in June

Western Asset

Executive Summary

  • UK Prime Minister Theresa May suffered a stunning upset after calling an early election in hopes of shoring up support for her Conservative Party’s Brexit negotiations.
  • With no single party in the majority, the UK is now in the realm of minority party rule.
  • Prime Minister May still commands the largest party and thus has the first chance to form a new government.
  • The only viable route to a working majority lies with the Northern Irish Democratic Unionist Party (DUP), with whom PM May has begun negotiations.
  • UK assets and the pound sterling will be more volatile and attract greater risk premia over the next few months.
  • Given the volatility of events in the UK over the last two years, investors should not be surprised if they are faced with another UK election before the end of next summer.

When to hold and when to fold—the keys to success that every gambler knows. Prime Minister Theresa May clearly didn’t heed that sentiment when she decided in mid-April to call an early election, thereby forsaking a guaranteed three further years as Prime Minister for the prospect of a larger and longer mandate. The wisdom of that decision, universally applauded at the time as the Conservatives built up more than 20% poll leads, has to be called into question given the subsequent humiliating result.

After running one of the worst electoral campaigns in living memory, full of hubris, negativity and dirigisme, the voters decided that the out-of-favor Labour party was an alternative worth considering. The result of the UK General Election on 8 June was such that Prime Minister May was robbed of her parliamentary majority and the UK plunged into only its third hung Parliament since 1945. The Conservatives—having entered the election believing they would take over 30 extra seats—ended up losing 12, while the Labour party, led by Jeremy Corbyn, increased its total by 30. The reversal in fortune was stark. Rather than making gains in Wales and England as expected, the Conservatives lost seats. Ironically, the saving grace was in Scotland where a strong showing by Ruth Davidson’s Scottish Conservatives picked up 12 seats, helping to spare some of May’s blushes.

With no single party able to command a majority, the UK is now in the realm of coalition forming or minority party rule. Although the UK has no written constitution, the last coalition government formalized the process in The Cabinet Manual, according to which the incumbent government remains in office unless and until the Prime Minister tenders her resignation. An incumbent government is entitled to wait until the new Parliament has met to see if it can command the confidence of the House of Commons. If not, it must resign, whereupon a range of different administrations are possible, and all parties can engage in talks to determine who can command the confidence of the House. The outcome of such talks is likely to lead to one of the following types of government:

  • Single-party minority government where the party may be supported by a series of ad hoc agreements based on common interests
  • Formal inter-party agreement
  • Formal coalition government

Even though May has failed by her own metric—“if I lose just six seats, I will lose this election”—she is still in the driving seat. Being only eight seats shy of an absolute majority and just four away from a working majority, May still commands the largest party and thus has the first chance to form a new government. The options open to her are limited, with the Liberal Democrats ruling themselves out of going into coalition with anyone, and the SNP and Greens vigorously opposed to any accommodation with the Conservatives. The only viable route to a working majority lies with the Northern Irish Democratic Unionist Party (DUP).

In fact, Prime Minister May has begun formal negotiations with the DUP, and we’d expect an agreement soon, perhaps on a confidence and supply basis, akin to the first type of government described above, rather than a formal coalition. While this ends the immediate uncertainty over the future UK government and its stability, it does leave open a number of questions:

1) Long-Term Sustainability of Government?

While the Prime Minister may be able to get a Queen’s Speech (a list of the laws that the government hopes to get approved by Parliament over the coming year) through Parliament with the help of the DUP, the question still remains how long will the government endure. Prime Minister May is clearly damaged, probably irreparably. The carapace of tough, confident, stable leader has been thoroughly exploded. Her credibility shot, she remains in position on sufferance of the Parliamentary Conservative Party.

Conservative MPs’ desire for a change of leader, although high, has to be tempered by electoral arithmetic and logic. Replacing May now would be unduly problematic, potentially leaving the way open for Labour leader Jeremy Corbyn to be asked to attempt to form a government. Keeping May is essential to preclude this and to allow the passage of a Conservative Queens’s Speech.

However, once through government formation, the outlook becomes more opaque. With her credibility damaged and question marks over her ability to lead the UK’s Brexit negotiations, the urge to replace May will become acute. The mechanism by which an incumbent leader can be challenged is set down in the rules adopted by the Conservative Party in 1998. A leadership election can be triggered either by a leader resigning his or her office, or a contest can be triggered if 15% of Conservative MPs write to the Chairman of the backbench 1922 Committee stating they no longer have confidence in the leader. After the 8 June election, this equates to 48 MPs.

Usually, resignation is forced upon a reluctant leader when a cabal of senior ministers make clear that they can no longer support the status quo, causing the incumbent to tender his or her resignation. This is what happened to former Prime Minister Margaret Thatcher in 1990. Despite winning the first round of the leadership election, her cabinet colleagues withdrew support, ushering her political demise. As Conservative Party history has shown, “he who wields the knife, never wears the crown”, makes it very unlikely that this will be the option taken. The catalyst for a challenge would thus have to come from the 1922 Committee. While this will not happen before a Queen’s Speech, it is likely to come over the summer. The motivations? To invoke another election in short order, and to take advantage of the fact that May is too damaged to credibly lead the party into it.

The narrowness of a combined Conservative/DUP majority makes an early General Election highly likely. By coupling with a Northern Irish party, the Conservatives open themselves up to all the problems of the internecine Ulster political environment. Whether the support of the DUP is worth the candle if it begins to affect the wider Northern Irish peace process is questionable. Even assuming the best outcomes, and the agreement progresses smoothly, the natural attrition of politics can quickly erode majorities. As John Major discovered in the 1990s, MPs’ health and peccadilloes can soon take their toll. With the odds of another election this year as low as 2-to-1, the necessity of having an electable, credible leader in place is paramount. Especially as he or she will have to overhaul the Conservatives’ policy proposal to overturn the inroads Corbyn’s Labour Party has made into their heartlands.

2) Policy Direction?

Despite the early talk of the election being centered on the Brexit negotiations, the Labour Party—by confirming that it would uphold the referendum result—neutralized it as an election issue and managed to focus the electorate on domestic policies. The so-called “strong and stable” campaign run by the Prime Minister had little new or positive to offer voters in an era when large swathes of them are looking for change. The one new policy that was proposed, the reform of social care, alienated their own supporters and was quickly characterized as the “dementia tax”. The state pension triple lock (guaranteed annual increases) was abandoned as tax cuts were downgraded to an aim rather than a pledge. The statist hue of the mandate was closer to a Labour rather than a Tory manifesto. This ceding of the economic narrative, and particularly the anti-austerity message, to the Labour party not only contributed to the poor election outcome, but has led to a laying of the foundation for the battleground of the next election.

Having failed to read the zeitgeist of the electorate over the past two months, the risk is that the Conservative Party, in an attempt to recover the lost ground in England and Wales, moves away from fiscal consolidation and towards a more activist policy. Certainly, under Prime Minister May, the likelihood will be that she tacks economic policy towards a looser fiscal stance. This would, in our opinion, further push out the point at which the UK economy returns to fiscal balance, most likely into the 2030s. Even under a new leader, the exigencies of a minority government and potential election will prevent him or her from moving policy back towards the liberal, pro-market economic policies of the Thatcher era.

The clear challenge to Conservative success in the next election comes from the re-engagement of the youth vote. Between 1964 and 2015, youth participation more than halved, falling from 89% of all eligible adults under 25 to just 43%. This trend was spectacularly reversed in 2017 with preliminary estimates of youth participation at over 70%, aiding the upset in the polls on 8 June. The move in constituencies with university and college populations was pronounced, as the youth surge helped turn seats that have been held by the Conservatives for a hundred years, such as Canterbury, to Labour. Connecting with this demographic will be a key policy aim. Whatever it takes, there is no doubt it will involve money, whether that is some movement on tuition fees or a fiscal means of ameliorating the wealth divide between the young and the old.

3) Brexit Negotiations?

Whatever the duration of this Parliament or the future position of Mrs. May, one thing and one thing only is going to dominate the government’s agenda: the negotiations with the EU over the UK’s exit. With Article 50 enacted on 29 March, the UK is already three months into the 24-month negotiating period. The clock is ticking.

The prima facie reason for the Conservatives’ calling the election was to deliver the country a large majority and thus a strong mandate for its negotiating position. The Conservative agenda—as outlined in May’s Lancaster House speech in January 2017 and the government’s subsequent whitepaper on the UK’s exit from and new relationship with the EU—is clear in what leaving the EU means and the primary objectives of the negotiations. Central to the exit strategy is that the UK is fully leaving the EU and that means “not partial membership…associate membership…or anything that leaves us half-in, half-out. We do not seek to adopt a model already enjoyed by other countries. We do not seek to hold on to bits of membership as we leave.”

The main objectives of the negotiations are to take back control of the law-making process, including the ability to control immigration from Europe, free trade with European markets, trade agreements with other markets and the maintenance of the common travel area with the Republic of Ireland. Going into the election, what was clear was that the manifesto commitment that “no deal is better than a bad deal” was a central tenet and one that the die-hard Brexiteers will hold PM May to in the final reckoning. The election result has thus changed this dynamic.

It is evident why the Conservatives are happy to co-operate with the DUP given that we estimate 100% of their representation (8 MPs) voted for Leave. This contrasts with around 40% of Conservative MPs and less than 10% of Labour MPs. The members of the opposition parties were nearly unanimously for Remain, although in the Labour Party’s case their election manifesto was unambiguous in accepting the result and committing the party to negotiating the UK’s exit from the EU. Consequently, on a manifesto pledge basis, 590 out of 650 MPs elected on 8 June 2017 support the UK’s exit from the EU.

So, can May and the Conservatives deliver on their Lancaster House wish list? It will be difficult. The minority nature of the government means each wing of the party has a disproportionate influence on the negotiating stance and the ability to get Brexit legislation through Parliament. The rebuttal by the electorate, as some would see it, of the Prime Minister’s cri de coeur, will embolden the “soft” Leavers and Remainers, and may lead to an erosion in the negotiating position. Against this, work by the Conservative European Research Group points to a block of 80 MPs committed to “hard” Brexit. More than enough to cause the government problems if sufficiently unhappy with the lack of implementation of the manifesto agenda. Ultimately, the supposition remains that the PM will have to revert to cross-party support to get her Brexit legislation through. Given that the Labour manifesto is firmly against a “no deal” outcome, this suggests the likelihood of a compromise “softer” Brexit has risen substantially since the election.

Underlying any presumptions regarding the Brexit stance and negotiations is the Prime Minister herself. Has her credibility been so fatally damaged that she goes into the negotiations with the EU at a severe disadvantage? Will the hung Parliament make the EU more recalcitrant knowing Labour would sign up to any deal? If the answer, as we would suspect, is yes to these questions, the Brexit negotiations will be fraught and more binary than before. If agreement can be reached in Parliament over the approach that a softer Brexit is more likely, but the EU press its perceived advantage too far, then the hard-line Eurosceptic wing may ensure we have “no deal” after all.

Market Implications

Markets do not like uncertainty, and the UK General Election of 2017 has injected substantial new amounts of doubt into UK financial markets. The UK government’s durability and stability is prime among the reasons for this but so are the economic and Brexit-related impacts. UK assets and the pound sterling will thus be more volatile and attract greater risk premia over the next few months.

While it is too early to tell whether or not the hung Parliament will impact domestic consumer confidence, we can assert that the direction of travel in terms of fiscal policy has to be a loosening rather than a tightening. This should give a marginal boost to growth, but, given the margin for error around its impact and the continued pressure on real incomes, we do not expect the Bank of England (BoE) to respond by tightening monetary policy. Uncertainty does not need to be compounded by raising interest rates. We thus continue to look for the BoE to maintain its current policy stance until the end of the decade. Short- to medium-dated gilt yields will thus remain anchored, as larger risk premia will raise long-dated yields, steepening the yield curve.

In the very short term, sterling may weaken slightly, but given its already very cheap levels, the downside is limited. With the prospect of a “softer” Brexit increased, sterling in fact may resume its recent appreciating trend. The Brexit outcome will also impact equities and corporate bonds. A softer exit will obviously help those companies with the most exposure to the single market, aiding their equity share and bond prices.

Given the volatility of events in the UK over the last two years, investors should expect the unexpected, and not be surprised if they are faced with yet another election before next summer is out.

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