United Kingdom: May's Way or the Highway

On April 18, Theresa May called for snap elections to be held on June 8. This came as a big surprise to analysts and investors alike and was perceived as an effort to consolidate powers ahead of Brexit negotiations. Labour bought into it and supported Theresa May’s motion for snap elections, even though the opinion polls at the time made the party look like a Turkey voting for Christmas.

However, the polls are tightening. The odds that the Conservatives lose their majority and that the UK ends up with a hung parliament – which seemed unlikely right after the election announcement – are now increasing. In recent days, this has led to increased volatility in sterling. The political backdrop is unusually complicated and the currency could be facing a volatile period dependent on the result of next week’s election.

But it’s not over after 8 June. The formal Brexit negotiations still have to start and the elections will have a major impact on the Brexit outcome the UK is aiming for. If the Conservatives lose their majority in the House of Commons, uncertainty about the negotiations and the eventual Brexit outcome increases.

The UK is divided into 650 different parliamentary constituencies. Each constituency is represented by one Member of Parliament – who typically has deep roots in the district he/she represents – in the House of Commons.

The system that is used is known as first-past-the-post (FPTP). FPTP simply means that to become a Member of Parliament all a candidate has to do is to gain more votes than any of his/her rivals in that constituency. The consequence of this is that there are 650 separate “Winner Takes All” campaigns and races, in which the line between local and national issues may sometimes be hard to draw. However, an even more important implication is that the number of seats won by the political parties is not directly related to the vote share.

If a party wins one more than half of these races, it will have an absolute majority in the Lower House and enjoys the benefits of majority government. In the past, this has almost always been the case. The FPTP voting system clearly favours bigger parties over smaller parties (see figure 2) and it’s hard for an upcoming party to change the system and seriously challenge traditional parties. Labour usually accumulates most of its safe votes in industrial regions and inner cities, whereas the Tories have a stronghold in the suburbs and the countryside.

The system discriminates against smaller parties, such as the Liberal Democrats, UKIP and the Greens. These three parties get appreciable levels of support across the UK, but are often too small to come in first in a single constituency. This doesn’t mean that they don’t have any influence on events in Westminster, as Brexit – which was initiated by UKIP – has evidently shown. Finally, parties who concentrate their campaigns in a limited number of constituencies, such as the Scottish SNP or the Welsh and Northern Irish parties, are much less affected by this. In fact, if we compare the FPTP seats to a proportional distribution, we see that the SNP enjoyed a “FPTP dividend” of 25 seats in 2015!

In the days that followed the announcement of snap elections, the Tories extended their already impressive lead in the polls. However, recent data show that their margin over Labour has narrowed significantly after a backlash over the Tory Manifesto. This included a key proposal to make pensioners pay for their own care at home until the value of their assets – including their home – reached a floor of GBP 100,000. The proposal quickly went viral as the dementia tax and regardless of whether that’s a fair representation of what was in the Manifesto, the meltdown in the polls certainly falsified the “There’s no such thing as bad publicity” hypothesis. Theresa May subsequently had to do some serious damage control and made an unprecedented U-turn on social care, which involved an “absolute limit” on the amount every individual would be expected to pay before the state funded their care. Nonetheless, it has damaged her standing and may also have tarnished confidence in her credentials in the forthcoming Brexit negotiations.

It looks to have hurt them badly in the polls. When Theresa May called the election, she looked convinced that almost nothing she could do or say would prevent a sweeping victory, but the polls in figure 3 show otherwise. The usual disclaimers still apply, but the landslide looks to be sliding away. If we look at the median of the last seven polls, the Tories’ lead has narrowed from about 22 ppt. the days after the surprise announcement to “just” 9 ppt. now.

Even though that’s still a relatively comfortable margin, it’s small enough to start worrying about the amount of seats the Tories will be able to win. Are the Tories still able to extend their current 6-seat margin or will the elections turn out to be May’s Miscalculation?

It’s hard to tell because of all these individual races, but fortunately, there are a number of projects that translate polling data into seat predictions. This is a challenging task and an art rather than science. For instance, some of the high-profile MPs – or those who have deep roots in the local community – have a relatively high “incumbency factor” while others clearly don’t. Obviously, it leaves a lot of room for judgment[1].

A recent YouGovprojection deserves attention, as it suggested that the Conservatives could fall 16 seats short of an overall majority. This would imply a hung parliament, spell disaster for May and show that her gamble has misfired. Their model is based on 50,000 interviews and the pollsters assessed the voting intentions of every type of voter, including age, social background and how they voted in the referendum. They then combined this with historical election data and census data from the ONS to come up with the figures in table 1. It’s an unorthodox way of polling – and it’s possible that they’re completely wrong – but it shows that May took a lot of risk.

[1] N.B.: Due to demographic shifts, some of the electoral districts have become considerably more populated than others. This means that the district boundaries need to be redrawn. This exercise was scheduled to be completed in 2018 and this means that next week’s elections will take place under the existing boundaries. In this sense it may be beneficial that the districts are the same as in 2010 and 2015 as it could increase the accuracy of the projections.

Finally, let’s make use of the wisdom of the crowds and see what the bookies are currently quoting. Interestingly, the implied probability of a hung parliament has increased in the past few days to a little over 20%.

Based on the polls, it was widely expected that the 2015 elections would yield a hung parliament. It was therefore a big surprise that the Tories managed to eke out an absolute majority, albeit a very slim one. Brexit sentiment most likely played a big role in this upset and that Cameron’s bold promise for a referendum – which was mainly to sooth unrest within his own ranks – handed the Tories the victory.

Brexit is once again going to have a big influence on the elections. Surveys and polls indicate that many who voted Leave at last year’s referendum have migrated to the Conservatives, as they feel that Theresa May is doing an adequate job in protecting their interest as she pursues a clean break with the EU. Her strong and stable slogan is way too simplistic, but does resonate with voters. However, her campaign gaffes aren’t doing her any good. With the Tories fully embracing UKIP’s main cause, the latter party has become irrelevant even more so because the FPTP voting system incentivises UKIP supporters to vote strategically on the Conservatives

Remain voters – on the other hand – remain divided and are therefore more likely to vote for the same party as they did in the 2015 elections. After a long period of confusion and indecisiveness, Labour appears to have opted to favour a soft stance on Brexit and to look for common ground between liberals (who would’ve preferred to remain in the EU) and its traditional working-class voter base (who – in general – were in favour of Brexit). Criticism has been that a soft Brexit is not a very coherent message as it could be interpreted as half-in half-out. It suggests that Labour can’t decide whether it favours globalisation or protectionism.

However, Corbyn also said that he would not “play by the rules”, that the “rigged system is set up by the wealth extractors for the wealth extractors” and that his party would “put the interests of the majority first” turning the social-democratic party into a left-wing populist party. He has plans to nationalise mail, rail and energy firms and goes on by saying that everything else is broken as well, including – but not limited to – the NHS, the education system, the environment, the budget and the labour market. It’s all a bit of a stretch, but at least this message is being heard.

The Liberal Democrats appeal to Remainers by promising to give the British people a final say on the Brexit deal. If it looks to be a bad one, the public should be able to reject it in a final referendum and the UK should then remain Europe after all. Practical and legal issues aside – some lawyers argue that Article 50 is irrevocable – this is a very, very, long shot.

In 2015, the Scottish National Party won all but three of Scotland’s 59 seats. Although they’re still performing well in the polls, it will be very hard for them to match that impressive result. Even if they lose some seats, we may still expect the SNP to ramp up their Scoxit-rhetoric (NB: they don’t have an overall majority in the Scottish parliament), arguing that a majority of Scotland does not want to leave the EU. A referendum on Scottish independence would require the approval of Westminster, which – if it will be up to Theresa May – the SNP is unlikely to get before the UK leaves the EU.

We won’t discuss the ins and outs of all manifestos at length, but those interested can find the manifestos of the five largest political parties in table 2.

Table 2: Manifestos of the five major political parties

Thus far, the UK’s negotiation position regarding Brexit was entirely formulated by the Conservative Party, and more precisely by Theresa May. However, based on the latest polls, it has become a realistic possibility that the Tories lose their majority in the House of Commons. This would have implications for the UK’s negotiation position and thus the outcome of Brexit.

A majority for the Conservative Party

The current polls are still pointing towards a victory for the Conservatives, although it probably won’t be as large as Theresa May had hoped for when she decided to push for snap elections. A smaller majority than previously expected would probably still give her a stronger Brexit-mandate domestically, as it should help her getting “the chickens back in the coop”. Each Tory MP now knows what he or she has signed up for: the new Tory Manifesto including Theresa May’s negotiating strategy for a “strong and stable” Britain outside of the EU and its Single Market.

Unless Theresa May significantly deviates from this strategy, it will be difficult for Tory MPs to credibly orchestrate a backbench rebellion. The current six-seat margin also gives backbenchers a lot of influence and this complicated May’s negotiating position. A bigger margin will thus make it easier for May to make a transitional deal if necessary and to sell the outcome of the trade negotiations to Westminster. This is more than welcome, as it would increase the likelihood of an orderly and smooth Brexit, preserving continuity for UK and EU businesses. What this would mean for free trade is still uncertain. Thus far, Theresa May has been taking a hard line approach, however, it remains to be seen whether her mantra ‘No deal is better than a bad deal’ is just bluff, or if she really means it.

No majority for the Conservatives

Should the Conservatives lose their absolute majority, uncertainty about Brexit negotiations and the eventual outcome will increase. Labour favours a soft stance on Brexit. An outright majority for Labour would therefore increase the likelihood of a soft Brexit, which will be positive for economic growth in both the UK and the EU in the long term. However, the odds of a Labour majority are very small.

The Brexit process could become increasingly complicated if neither the Conservative Party nor Labour wins a majority. The UK will then end up with a hung or minority parliament. The UK’s stance towards Brexit could become softer if the Tories are forced to cooperate with more pro-EU parties, or if these parties are able to form a coalition (which was once dubbed the “coalition of chaos!”).

A soft Brexit would naturally be positive for economic growth in the UK, but the lack of a majority in the House of Commons will raise the risks of a ‘cliff-edge’ Brexit as it will be much harder to pass Brexit-related legislation. Furthermore, a new government will probably want to revise the current stance on Brexit which is mainly written by Theresa May. This will take time and could further delay the Brexit negotiations, while the two-year clock already started ticking.

Will Brexit be cancelled?

Even when pro-EU parties are able to form a coalition, it won’t mean that the UK wants to cancel Brexit. Labour is campaigning for a soft Brexit, after all, so those who voted Remain last year shouldn’t get their hopes up. However, it is possible that a (second) referendum on the final deal will be held, especially if public sentiment changes radically in the course of the next two years. The economic impact of the Brexit vote has been modest in the second half of 2016 (the first six months after the referendum), but the negative effects of the Brexit vote have started to reveal themselves to households in the first quarter of 2017 (figure 6). After the unexpected outcome of the referendum, the pound depreciated strongly against the currencies of its major trading partners. This has been driving up inflation (2.7% in April) since, but inflation only surpassed nominal wage growth in the first months of 2017. If household purchasing power continues to deteriorate over the course of the next two years, public sentiment towards Brexit could change. It is fair to note, however, that other events – like terror attacks – could increase anti-EU sentiment.

Aside from the uncertainty around the question if the UK would want to remain a member of the EU after all, we would also like to emphasize that it’s not clear at all whether it’s legally possible to revoke Article 50.

Impact on the EU negotiations stance

Irrespective of the mandate that the Prime Minister will be handed after the election, the main aim of the EU27 remains the preservation of coherence in their union. Recent signals suggest that EU negotiators don’t really care whether the PM has a comfortable or a slim margin in the House of Commons, as they are likely to take a hard-line approach anyway. Indeed, on May 22, the EU reiterated this when it finalised its negotiating position. It will stick to its widely communicated sequence of “first a divorce, then a new relationship”, meaning that the UK has to settle its divorce issues before it can talk trade. The sheer size of the exit bill, which some estimates put as high as EUR 100bn, suggests that the UK economy is at risk of bearing a heavy cost to enter into trade agreements with the European Union[2].

[2] The European Commission hasn’t put a figure on the Brexit bill yet, but says that its calculations cover the period after Britain’s departure from the European Union. This is highly unpopular by those who supported Brexit and will be strongly contested. The draft EU position papers can be found here.

Currencies tend to react favourably to expectations of a strong, liberal and above-all market-friendly government. When the elections were announced, the polls indeed indicated that the UK was likely to be handed such a government, and, just as crucially, a five year period free of any electioneering. With regards to Brexit, a strong parliamentary majority helps in selling the negotiations domestically. Theresa May is currently being pulled in multiple directions, which potentially leads to in- and external political conflicts and a cliff-edge Brexit. If the Tories are still able to increase their majority and overcome their internal divisions on Brexit, the risk of such a dramatic scenario reduces. This explains the surge in sterling on April 18.

We would however argue that the recovery of sterling was amplified by the fact that speculative short positions had recently reached record levels. The reason that these negative bets had reached such extreme levels was the result of anxiety connected with Brexit. While the market is still short sterling, there is evidence that the recent round of position adjustment is over.

While it is difficult to squeeze the current complexities of UK politics into a binary universe, the behaviour of the pound this year suggest that a relief rally would likely follow a strong victory for May next week, while the pound could fall on any other outcome. Regardless of the election outcome, we continue to expect that Brexit related uncertainty will weigh on the pound again in the coming months. Given that the Brexit negotiations are due to start on June 19 and that these are likely to be tough, we expect EUR/GBP to edge towards the 0.89/0.90 area by year end.