The financial markets get political

How will the outcome of the election affect the financial markets and the wider economy?

The general election campaigns are narrowing the final strait. However, at a time when the UK is under pressure to implement stringent policies to reduce its £163bn fiscal deficit, the unsettling prospect of a hung parliament is causing major concerns in financial circles for both sterling and the sterling bonds, also known as gilts.

Opinion polls are given conflicting results, which in itself underlines the increasing risk of a hung parliament. The possibility that there will be no clear winner will create a protracted war of attrition between the two ruling parties that will have ramifications on how and when economic policies are introduced. Major worries rest on Prime Minister Gordon Brown's restrained plans to cut the deficit, while Conservative leader David Cameron's has promised an emergency Budget within 50 days of gaining power. The very likely outcome of more austere public spending measures in either case is not to be overlooked given that by the end of 2010 the fiscal deficit will account for 12% of GDP and the financial markets are undoubtedly poised for this. However, in a worst case scenario of a coalition government, even transiently, the delay to the much-needed fiscal restraint and will prolong the UK's economic woes.

On a political risk level, there is a reasonable chance that, in the event of a hung parliament, even post-election, politicians will remain in 'campaigning' mode, anticipating that another round of elections will be called. With the scale of the UK's budgetary concerns, tentative decision making is not a desirable situation. In response, Whitehall has put together a document which will clearly outline the constitutional protocol for how to proceed in the event of a no-majority election outcome. Since the UK constitution is otherwise designed so that hung parliaments are rare, the appearance of the Whitehall manual at this late stage adds both an element of reassurance that a lengthy impasse will not be allowed to heighten risk in the UK financial markets, as well as adding weight to the expectations that there will indeed be a hung parliament.

A chief concern is the UK triple A credit rating. On a fundamental level, the financial markets tend to view a coalition government in the UK as a decidedly negative outcome. Obviously, how long this negativity lasts depends on how long it takes for a new government to be established and critically, whether it is able to push through urgent fiscal tightening measures with credibility. Another factor is how each party's economic programmes differ and which model is more desirable for economic recovery. Disparate policies will generate more extreme speculation but in this case both Labour and the Tories are putting forward broadly similar economic policies owing to the stricter spending conditions that are essential to embark on economic recovery and regain confidence in the financial markets.

What are the Implications for Sterling?

For pound sterling, there are serious considerations. Risk premiums for the G10 countries including the UK have risen in previous months owing to the rise in government debt. Question marks over how robust the UK's sovereign risk case is faring understandably creates an element of fiscal instability. With the general election imminent and moreover, bringing a rare and unwelcome likelihood of a hung parliament with it, pound sterling is particularly vulnerable to further depreciation. Indeed, the pound has experienced a 10% decline against the US dollar since December 2009. However, a more optimistic view would point to a gradual recovery for sterling post-election as stricter government spending policies are inevitably introduced. Current speculation suggests that if there is a clear majority for either Labour or the Conservatives post-election, the pound could enjoy a temporary appreciation. Thereafter, it's likely that the long road to recovery will be a bumpy one, depending heavily on when and how well government budgetary policies are carried out. On the other hand, a period of sterling depreciation should make the UK's exports more attractive and raise capital inflows.

What are the Market Implications?

It is important to understand that political sensitivity is higher in the bond and currency markets. The FTSE 100, for example, is not a true representation of the UK economy - with 75% of FSTE All Share index revenues being generated from outside the UK. The global nature of the UK equity markets should protect stocks from political fallout, should there be any. If anything, the global economic recovery is likely to play a significant role in the UK equity markets, with so many of the FTSE 100 companies focused in oil, gas and mining.

However, small and mid cap companies which account for the 25% of earnings that are domestic could feel the main impact of domestic politics. Furthermore, some areas of the UK equities market could be directly affected by political decisions than others, such as so called 'sin taxes' which would likely hit pubs and bookmakers hardest.

UK bonds (gilts) have been underperforming in the run up to the election, with rising risk premiums attached. In any case, uncertainty is causing serious worries and could be pacified by a straightforward winning result - chiefly because a steadfast majority will enact prudent spending more decisively and quickly than a coalition could. That said, any risks of downgrading the UK's credit rating could be lowered in the event of a Conservative or Labour majority.

This justified fear of Britain losing its AAA credit rating through a hung parliament has yet to be fully reflected in gilt prices. It is likely however, that as polling day draws nearer and the outcome is less certain, it is possible that UK bonds will look to price in a possible hung parliament, bearing in mind the fact that a coalition-style government may not be able to tackle the budget deficit as severely as necessary. However, it is not all doom and gloom for gilts. Should a strong Conservative majority be the election result and an immediate programme of significant fiscal policies were to be implemented then it could be seen as positive for the gilt market, which will mean that yields will get pushed lower.

Overall, the situation is pretty tense but despite the financial crescendo that will follow the election it does give a remarkable insight into the rare impact of a hung parliament. It's undoubtedly a critical time in British politics and more so for the economy - even the newly televised debates add another dimension of excitement. Whatever the outcome, the state of the UK finances will continue to stir speculation from even the most casual observer, giving politics a dynamic financial edge.

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