Why the 2015 election could be disastrous for the pound

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Forget looming interest rate hikes, deflationary pressures, rising consumer spending and stronger than expected services PMI growth. The biggest near-term threat to the pound sterling (GBP) is the 2015 general election.

After a prolonged period of strength for the GBP, which has made holidays abroad cheaper, imports more attractive and given the UK consumer greater spending power, we could be set for a period of pain, at least in the short-term.

Five reasons why the 2015 election will hurt the pound

The 2015 election will be long remembered as the first major election where its minority parties could effectively become ‘kingmakers’. The Conservative and Labour parties are both expected to win the large majority of the votes, but still fall significantly short of the 326 seats needed to win the election. This means a coalition is highly likely and as such, it will be an alliance with a minority party that will determine who rises to power.

But what does this mean for the pound sterling? I’ve highlighted below five key factors that will create high volatility in foreign exchange markets and could hurt the pound significantly during the election period.

1. Investors hate uncertainty

The latest polls show both the Conservative and Labour parties neck-and-neck at 34% of the vote each, which would historically translate to both parties winning around 270-290 MPs in the House of Commons. That is short of the 326 MPs needed to secure a majority and form a government. So if the polls remain as they are going into Election Day, the chances are no major party will secure a majority. This would then require what’s known as smoking room deals between major and minor parties in an effort to secure that majority.

The main point here is no one has the slightest clue as to which party will govern the UK from May 8th. In the 2010 election it took almost 24 hours after the polls had closed before the public knew that the Labour party was out, and a coalition between the Conservatives and Liberal Democrats were in. With a coalition either in name or in ideological support almost certainly required this time around, we simply won’t know who will govern the country for some time after the polls shut. And worse, even if there is a coalition made, it won’t be until the 2015 budget is passed some weeks later that the potential for a new election will pass.

All of the above creates huge uncertainty and investors hate uncertainty. The typical market reaction would be a flight from risk and in this case, any continued uncertainty would likely see flights from the pound to other safe haven currencies, like the US dollar.

2. European membership at risk: the Brexit debate.

The debate around the UK’s EU membership is now firmly back above the parapet and the risk of a Brexit (Britain exiting the EU) will be considerably higher over the next parliament depending on the dynamics of the next government.

The good news is it’s fairly transparent where each party stands on being a member of the EU and therefore what is likely to happen should they get in power.

Where the major parties stand on EU membership:

• Conservatives – Will let the public decide with a referendum by 2017
• Labour – For EU membership
• Liberal Democrats – For EU membership
• UKIP – Against EU membership
• SNP – For EU membership

Early murmuring from many business leaders has focused on the one clear benefit of a Labour government is that it would maintain the UK’s status quo with Europe. Labour is pro EU membership and in the very least, there is no uncertainty towards the EU membership that would be created from a Conservative government or coalition with UKIP.

Business is fundamentally pro EU membership. A recent RSM-European Business Awards survey highlighted that 76% of business leaders believed a Brexit would hurt the UK economy and 56% said it would damage their own businesses. Europe is Britain’s largest trading partner and UK businesses enjoy free trade to more than 500m people in the largest single market in the world. Whilst debate rages on about how leaving the EU would affect those trade dynamics, business leaders are united in their opposition to a Brexit and the effects it could have on their own businesses and thus, the UK economy.

Any government or coalition that threatens the UK’s EU membership will see a negative market reaction. In this sense, a Labour or Labour/SNP coalition might be more warmly received that initially feared. On the other hand, any Conservative/UKIP combination (formally or informally), could see the market increasingly concerned.

3. Scottish Independence debate could reignite

The rise of the Scottish National Party in stealing the traditional Labour vote north of the border, alongside the strong performance of its leader Nicola Sturgeon in the televised leaders’ debate has brought the issue of Scottish independence back to the fore.

With Labour and Conservatives stuck polling at 34% each, it’s the minority parties that will play a crucial role in who wins out on May 7th. In Scotland, Labour currently has 40 MPs compared to the SNP’s 6 MPs. After the election, this is likely to change dramatically. Current polling suggests that the SNP could win up to 50 seats stealing as many as 30 Labour seats in the process. The key part here is Labour will likely rely on SNP MPs to help them get across to the magic 329 number needed to form a government. Assuming this is the most likely scenario, SNP will become kingmaker and thus determine the grounds on which they will support Labour. The SNP has made no secret of its aim at giving Scotland more independence and the potential for another referendum further into the next parliament simply cannot be ignored.

The GBP endured high negative volatility during the Scottish Referendum vote and so it’s easy to see here by a Labour/SNP coalition could trigger a similar impact if it emerges another referendum has been successfully negotiated.

4. Business confidence will suffer at a vital time

There has already been some evidence that uncertainty over the election result has begun to impact on business confidence and some businesses have scaled back spending.

There is no certainty that the next government will be immediately formed after votes have been cast. Whilst it took 24 hours before the Conservatives and Liberal Democrats combined in to a coalition, there is every chance that it could take much longer this time around. This is partly due to the fact that should no major party win enough seats, it is the existing government’s opportunity to first seek a coalition that would give it a majority. So it could well be up to David Cameron to first find a coalition partner. Whilst negotiations continue in the background, the lack of a visible government will hurt output and business confidence.

It’s also worth remembering that the GBP trades until Friday night and re-opens on Sunday night. So it is in this time where the GBP could be hurt the most if the market remains unclear as to who is the winner.

5. Short term monetary policy decisions could be affected

One of the clearest threats to the next interest rate hike by the Bank of England is the fact the UK is set to endure – albeit short-term according to latest projections – deflation (negative inflation). The pound’s strength (GBP has rallied 11% against a basket of other currencies in the last 12 months alone, hitting a near seven-year high in the process), which has been based on both the improving UK economy and rate hike expectations, has also been a deflationary pressure, forcing UK exporters to cut prices to maintain sell-side volume.

The Bank of England has been trying to talk down the pound in recent months, concerned that its strength could hurt exports. Election uncertainty could help to do just that, and a by-effect of this is it could help shorten the expected period of deflation and bring rate hikes closer into view. This seems a bit more of a long-winded possibility but it’s something which should not be discounted.

History repeating

The 2010 general election and Scottish Independence referendum both provide strong case studies for how the pound should trade during the 2015 election. Of course, the past is never a 100% representation of what will happen in the future, but it’s naïve to not use historical market reactions as a point of reference for how the markets could trade.

2010 General Election

During the last election, the pound suffered greatly due to the high level of uncertainty created by the lack of visible winner and as Labour and the Conservatives entered into the backrooms to negotiate a coalition with the Liberal Democrats. The uncertainty over who would win out and the impact on the massive UK budget deficit, with a potential credit rating cut to come, saw traders sell the GBP aggressively, seeing the pound lose 1,150 pips against the US dollar.

It’s also worth pointing out the relief rally once the Tories confirmed a coalition government would be formed with the Lib Dems. We could see a similar pattern this time around.

Below is a chart of how the GBP traded against the USD over the course of the 2010 election.

Scottish Referendum

We saw similar GBP selling into the Scottish Referendum. When polls showed that the chances of a yes vote to independence had increased, investors sold the GBP out of fear. However, with a week to go until the vote, the polls showed that a no vote was more likely, which created a relief rally for the GBP. The main point here is to expect GBP weakness in the run up to the election if the polls show it’s still too close to call.