“Investors have greeted the result of the UK general election with relief. The overnight boost to equities, sterling and gilts is understandable and likely to be sustained in the short term. But it is important for investors in UK assets to realise that none of the factors that will do most to shape Britain’s medium-term outlook has been resolved by this surprisingly clear-cut result.
The immediate and marked response of the markets reflects a significant turnaround in sentiment. But even this very surprising result cannot outweigh the more global forces that have hit UK asset markets in recent weeks: the price of ten year gilts are still lower than they were at the start of April as yields have surged across global fixed income bonds. That speaks to the larger point we have been making for several months - that the election outcome is important for UK markets and the economy, but other things matter more.
One clear consequence is that fiscal policy is likely to be somewhat tighter over the early years of this parliament than it might have been under a Labour-led coalition. Other things equal, this would suggest that interest rates might be somewhat lower than otherwise, because the Bank of England might need to keep rates lower for longer to maintain an equivalent amount of domestic demand. That, in turn, might be expected to produce a modestly lower pound. But we have learned in recent years that other things are not equal - either for sterling or for interest rates.
There may be some impact at the margins from lower medium borrowing and spending, but overall we believe the strength of the global recovery - growth in Europe, especially - and the pace of UK productivity growth will have a greater impact on Bank of England policy and the value of UK assets than the precise level of UK public spending and taxes.
The issue of Britain's membership in the European Union is a big factor shaping Britain as an economy and an investment destination — one which apparently will be affected by this election result. David Cameron has assured us that Conservative-led government will hold a referendum on remaining in the EU within two years.
Financial markets consider this the main negative from this Conservative victory, because we will have further uncertainty hanging over the UK until the vote on Europe is held, with potentially malign effects on business confidence and investment. But it is worth nothing that we have seen a big improvement in both of these things in the past 18 months - despite all the uncertainties surrounding the Scottish referendum and the general election.
There could indeed be a short term hit to investment in the run-up to any referendum. But the likely future shape of Europe has changed dramatically in the past few years, and so have UK popular attitudes towards it. Both these developments are making it more difficult for the UK to remain in the EU on the same terms as before and greatly increasing the probability of a referendum on EU membership.
Put it another way: the question of Britain’s continued membership in the EU was going to remain on the agenda, regardless of who won power and how long they kept it. It is not obvious that a referendum held in 2016 or 2017 is more likely to end in a UK exit from the EU than one held in 2020 — or even 2025. Nor can we say now which would cause more lasting uncertainty for business — or investment.
Investors do not like uncertainty and will be understandably relieved that UK voters have not produced as much of it as the commentators and pollsters were expecting. But on any reasonable time frame, Europe, the growth rate of productivity and the state of global demand are the most important factors shaping the course of Britain’s economy and its markets. They were deeply uncertain before May 7th and they remain so today.”
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