UK Election: Clutching Defeat from the Jaws of Victory

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With the votes having been counted for 649 of the 650-seats in the House of Commons, the ruling Conservatives have 318 seats, a net loss of 12 seats. Labour, the main opposition party, won 261 (+32).

Even if the Conservatives win the 650th seat, they will at best be 7 seats short of an absolute majority and 5 seats short of a working majority – a hung parliament.

Prime Minister Theresa May announced that the Conservatives would form an informal alliance with the Northern Irish DUP which won 10 seats. The DUP would support the Conservatives in key votes, likely in exchange for some say on government policy.

Theresa May’s future seems secure for now but medium-term I would expect her position to come under close scrutiny and a party-leadership battle remains a distinct possibility.

Sterling has weakened about 1.5% post election, in line with my and market expectations. The Conservatives’ loss of seats raises serious questions about Theresa May’s leadership, her decision to trigger early elections and the risk of a party leadership battle to oust her.

Moreover, markets will likely remain concerned about the shelf-life of a Conservative-DUP alliance and its ability to push legislation through parliament.

However, I also see scope for Sterling’s downturn to fade and even reverse in due course. To be clear, a V-shaped Sterling recovery would likely remain elusive.

Two key questions pertain to the likelihood of this new Conservative-DUP formal alliance 1) securing an advantageous EU deal and 2) opting for a “hard” or “soft” version of Brexit.

If anything, the past two months have reinforced my view that the government is ill-equipped, ill-prepared and lacking in institutional capacity to negotiate complex deals with the EU and non-EU partners.

The composition of parliament and its take on Brexit leave Theresa May in somewhat of a bind. The government may therefore have little choice but to seek support from some of the 322 opposition MPs who on the whole favour the UK remaining in the EU or at the very least a “soft” version of Brexit.

So while I do not expect a second referendum on the UK’s membership of the EU, I do see a possibility of the government toning down its rhetoric and potentially opting for a softer version of Brexit – a development which UK financial markets would welcome in my view. 

At the very least, this election has further weakened the idea that nationalist parties in Europe are gaining the upper hand.

 

Conservatives win 318 seats, Labour 261 seats – Hung Parliament

With the votes for yesterday’s election having been counted for 649 of the 650-seats in the House of Commons (lower house of parliament), the ruling Conservatives have 318 seats, a net loss of 12 seats (see Figure 1). The other big losers were the Scottish National Party (SNP) and the Northern Irish Social Democratic & Labour Party (SDLP) and Ulster Unionists which lost respectively 19, 3 and 2 seats.

Labour, the main opposition party, won 261 (+32). The other winners were the Liberal Democrats and the Northern Irish Sinn Fein and Democratic Unionist Party (DUP) parties which gained respectively 3, 3 and 2 seats. The Speaker of the House of Commons, a Conservative who does not vote in parliament, also retained his seat.

 

olivier desbarres elections fig 1

 

Conservatives short of absolute and working majorities

Even if the Conservatives win the 650th seat, they will at best be 7 seats short of an absolute majority and 5 seats short of a working majority, calculated as Conservative Members of Parliament (MPs) less all other parties but excluding MPs who typically don’t vote in parliament[1] (see Figure 2).

 

olivier desbarres elections fig 2

 

Conservatives forge informal alliance with Northern Irish DUP

No party won a majority and therefore the UK has a hung parliament. Theresa May announced this morning, after having seen Her Royal Majesty the Queen, that the Conservatives would form an alliance with the DUP which has ten seats. This informal coalition would have 328-329 seats[2] – a wafer-thin majority of 2-3 seats and a working majority of 13-15 seats. The DUP would not formally be part of the government nor have ministerial positions in the new cabinet but would support the Conservatives in key parliamentary votes, likely in exchange for some say (at the margin) on government policy including Brexit negotiations (see below) – what is termed “Confidence and supply” votes.

This is in line with my view that should the Conservatives lose their majority “few, if any, of the other parties would likely have both a significant number of seats and a natural affinity with the Conservatives” and that while “the DUP and Ulster Unionists have given their tacit support to Brexit and could conceivably side with the Conservatives in key votes, they they would not formally join a ruling coalition” (see  UK General Election Scenario Analysis Impact on Policy, Theresa May and Sterling, 7 June 2017)

 

Theresa May’s future – Secure for now, far less so medium-term

While opposition parties have called for Theresa May to resign following yesterday’s election, within the Conservative Party there have so far only been rumblings about Theresa May’s position as party leader and Prime Minister. This is broadly in line with my expectation that in the event of Conservatives failing to win a working majority, “The near-term risk of the Conservatives holding a party-leadership election may, somewhat perversely, be more modest than in Scenarios 4-6. The reasoning is that the Conservatives would be under pressure to beat Labour in forming a majority coalition government and may not want the added distraction of a leadership-election which could leave the country rudderless.

In the medium-term, however, I would expect Theresa May’s position to come under close scrutiny and a party-leadership battle remains a distinct possibility.

 

Sterling drops post election result but scope for modest recovery medium-term

Sterling has depreciated in wake of the election result, with the Nominal Effective Exchange Rate (NEER) down about 1.5% according to my estimates (see Figure 3). The GBP/EUR cross has weakened about 1.2% at time of writing while GBP/USD is down about 1.5%.

This is line with my scenario analysis that “In the event of neither Labour nor the Conservatives winning a majority – a hung parliament – the immediate knee-jerk reaction would likely be a sharp sell-off in Sterling and jump in volatility. Sterling could conceivably weaken to (and below) the low-end of its multi-month range” (see Scenario 7 in UK General Election Scenario Analysis Impact on Policy, Theresa May and Sterling, 7 June 2017).

The Conservatives’ loss of seats raises serious questions about Theresa May’s leadership qualities, her decision back in April to trigger early elections and the risk of a party leadership battle to oust her. Moreover, markets will likely remain concerned about the shelf-life of a Conservative-DUP alliance and its ability to push legislation through parliament (i.e. policy paralysis). This concern is likely to be particularly acute with regards to a minority government’s ability to successfully negotiate a favourable deal with the EU – a body with arguably vast institutional capabilities.

However, I also see scope for Sterling’s downturn to fade and even reverse in due course. This Conservative-led alliance will likely have to adopt a more consensual stance on policy, including Brexit. This may in turn help mitigate the risk of the UK walking away from EU negotiations without a deal, even if transitional, in place. At the very least it may force Theresa May to be more transparent and detailed in her presentation of policy.

To be clear, a V-shaped Sterling recovery would likely remain elusive. After all financial markets generally distrust inherently less stable and predictable coalition governments, let alone an unprecedented informal alliance between a minority Conservative Party and a Northern Irish Party. Moreover, this minority government will have to deal with a trifecta of challenges – lacklustre economic growth, likely tortuous and drawn-out EU negotiations and the omnipresent threat to domestic security. However, the seemingly-held assumption that a hung parliament would usher in a protracted period of acute Sterling and financial market weakness may well be challenged.

 

 

What next for Brexit?

The British government and EU leaders are due to start negotiations in ten days time about the terms and conditions of the UK’s exit from the EU (see Figure 4) and in due course negotiations about the terms and conditions of the UK’s new deal with the EU. The two main questions pertain to the likelihood of this new Conservative-DUP formal alliance 1) securing an advantageous EU deal and 2) opting for a “hard” or “soft” version of Brexit.

 

1. Securing an advantageous EU deal

I argued in UK Election Special – When Two Tribes Go To War (2 June 2017) that the size of the government’s majority would have little bearing on the success of negotiations with the EU. If anything, the past two months have reinforced my view, first set out in The A-team had a plan, the British government has a nebulous goal (13 December 2016) that the government is ill-equipped, ill-prepared and lacking in institutional capacity to negotiate complex deals with the EU and non-EU partners.

 

 

2. Soft or Hard Brexit or something in the middle?

Theresa May made clear in her post-election speech that her government would respect last June’s referendum result and continue with its plans for the UK to leave the EU in March 2019. Conservative MPs have in the past expressed a broad spectrum of views with regards to Brexit. With the exception of Kenneth Clarke, all voted in favour of the Brexit bill back in February but a sizeable number did so reluctantly given that their constituents had voted in favour of remaining in the EU in the 23rd June referendum.

The DUP has in the past given its tacit support for Brexit so on paper an informal Conservative-DUP alliance with 328 seats would have the required working majority to push through parliament policies which take the UK out of the EU (see Figure 5). However, there are a number of stumbling blocks. First, the DUP has in the past expressed a preference for Northern Ireland to maintain free-trade arrangements with the Republic Ireland, which would in theory be incompatible with the UK no longer being an EU member. Moreover, 30 or so Conservative bankbenchers are in favour of a “hard” Brexit.

This could leave Theresa May in a bind. If on the one hand she pushes for a “hard” Brexit or even threatens to walk away from negotiations with the EU without even a transitory deal in place, the DUP may not give their parliamentary support. On the other hand, if she pushes for a “soft” Brexit – namely UK membership of the Customs Union and a tapered budget contribution to the EU budget in exchange for increasing control over EU immigration into the UK – she may run into opposition from rebel Conservative MPs.

The government may therefore have little choice but to seek support from some of the 322 opposition MPs who on the whole favour the UK remaining in the EU or at the very least a “soft” version of Brexit. This would likely mean Theresa May adopting a more conciliatory approach to the UK’s exit from the EU. So while I do not expect a second referendum on the UK’s membership to the EU, I do see a possibility of the government toning down its rhetoric of “no deal is better than a bad deal” (at least behind closed doors with EU leaders) and potentially opting for a softer version of Brexit – a development which UK financial markets would welcome in my view.

At the very least, this election has further weakened the idea that nationalist parties in Europe are gaining the upper hand (see 2017 French elections – They think it’s all over…it isn’t, 11 May 2017). Conservatives have suffered an embarrassing debacle while the pro-Brexit United Kingdom Independence Party (UKIP) won only 1.8% of the national vote versus 12.6% in the 2015 election (see Figure 1).

 

 

Conservatives won 42.4% of national votes but “only” 49% of seats

The Conservatives won 42.4% of the national vote, which was slightly higher than the recent historical average of 40% (see Figure 6). As a result of the first-past-the-post electoral system[3], the Conservatives won a higher 49% of the 650 seats.

 

 

However, the 6.5 percentage point (pp) gap between the two measures was the lowest in recent history and well below 15.6pp average (see Figure 7). This would suggest the Conservatives fought a poor tactical campaign. In effect, for the first time in decades, the election outcome resembles that of an election run under a Proportional Representation (PR) electoral system (in a pure PR of course the gap would be nil).

 

 

Turnout – Above average but scant consolation

Voter turnout, defined as the share of valid votes as a percentage of registered voters, was 68.7% based on preliminary numbers (see Figure 8) – only marginally lower than the historical average despite fears of a record-low turnout (that record is still held by Tony Blair’s Labour party in the 2001 general election). As a result the Conservatives won the support of approximately 29.1% of registered voters, slightly higher than the average – scant comfort to the party or Theresa May in my view.

 

 

You Gov got it right, national polls got in partly right

You Gov – the only polling agency which attempted to forecast the election result across all 650 constituencies[4] – correctly forecast a hung parliament. Credit where credit is due. Specifically they forecast:

  • Conservatives 304 seats (vs 318 actual)
  • Labour 266 (vs 261 actual).
  • Liberal Democrats 12 (vs 12 actual)
  • SNP 46 seats (vs 35 actual).

 

National opinion polls correctly estimated national support for the Conservatives and Liberal Democrats (see Figure 9). However, they significantly under-estimated support for Labour by about 5.5pp and to a lesser extent for the SNP (1pp) while they over-estimated support for UKIP (2.6pp)

 

 

My model significantly under-estimated number of marginal seats which Labour won

My own model, based on a number of assumptions, namely the net share of votes which Conservatives gain from other parties as well as voter turnout, had pointed to the Conservatives winning around 360 seats and Labour 212 (see UK Election Special – When Two Tribes Go To War, 2 June).

While I had anticipated, correctly it would seem, that the Conservatives would win seats from both the SNP and UKIP, I had also expected the Conservatives to in net terms to win seats from Labour in marginal constituencies. The opposite seems to have happened, with Labour successfully taking Conservative seats in marginal constituencies.

 

Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.


[1]. These are the Speaker of the House (who resigns from his/her party, at present the Conservative Party), the three Deputy Speakers (currently two Labour, one Conservative) who don’t resign from their parties and the four Sinn Fein MPs who do not sit in Parliament as they do not recognise its legitimacy. 330 minus 313 (320 minus 3 minus 4) equates to 17-seat government majority.

[2]. Depending on whether the Conservatives win the last seat for which votes have not yet been counted.

[3]. Under a winner-takes-it all, first-past-the-post electoral system a candidate is elected MP regardless of his/her margin of victory

[4]. Using national polls and analysis of key demographics, past voting behaviour and voter turnout to scale up the numbers

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