Counterpoint Snapshot: UK - The Political Implications

Counterpoint Snapshot: UK - The Political Implications

UK Prime Minister Boris Johnson has resigned as Conservative party leader. All eyes are now on the leadership contest, which is likely to start over the next few days. Market reaction, at this stage, is very limited. Perhaps pricing in diminishing uncertainty over time, the pound rebounded a bit, UK equity markets are up and gilts moving sideways. By and large, there was no immediate response following the first headlines, and these market moves are more or less in line with those of other markets today. Our tactical asset allocation has no active UK overweights and is underweight UK government bonds.

— Johnson’s resignation & market reaction: On the steps of 10 Downing Street earlier this afternoon, Boris Johnson announced that he would resign as Conservative party leader. However, he didn’t step down immediately as prime minister, saying that he would remain in office until a new party leader is chosen. A Conservative leadership election is likely to begin within days. While his resignation could add to near-term uncertainty, so far the market response has been fairly muted. Looking further out (past the current loss of growth momentum), the UK economy and its financial markets could perhaps benefit from more certainty. At the time of writing, markets are reacting minimally to the political newsflow. The pound has risen slightly against the dollar and the euro (by 0.2% and 0.4%, respectively). By and large, these are relatively small swings, even though they follow substantial currency weakness since the start of the year. The FTSE 100 is up about 1.3% at this time, with no market reaction following these headlines and with minimal differences vs continental European equity markets (which are up slightly more). 10-year gilt yields are broadly unchanged, at 2.1%, which is consistent with other global bond markets.

— How does the Conservative leadership contest work? The leadership race will be decided according to the election rules of the Conservative party. There are two stages: first, would-be leaders among Conservative MPs put their names forward and are whittled down in a series of votes among MPs until two remain; second, the party membership selects the winner. The 1922 Committee, which is the parliamentary party of all backbench Conservative MPs, will decide the timeline of key votes (possibly next week). The process doesn’t necessarily need a final vote by all party members. In 2016, Theresa May became leader after only two rounds of votes in the first stage – after winning 60% support of MPs, the other candidates dropped out of the race. The process in 2016 lasted less than two weeks. In 2019, when Johnson won in the second stage after five ballots in the first stage, the process took about seven weeks. The UK parliament goes into summer recess on 21 July. Otherwise, Johnson may stay until parliament sits on 5 September. The key question in the marketplace is whether the Conservative leadership election will be followed by a snap election once the new leader is in place.

How’s the UK economy faring? There’s been a generalised loss of momentum across Western economies, but in particular in the UK and the euro area. The US economy is slowing more moderately. Inflation is higher in the UK vs the euro area and the US, in part given the energy spike (which turned out to be more extreme) and the peculiarities of UK energy regulation (with the price cap to be lifted once again this autumn). While US core inflation (ex food and energy) has slowed for three months running, there’s no sign of UK inflation peaking just yet. The Bank of England is facing a more difficult trade-off between growth and inflation. The market has started to price out Fed and ECB rate hikes in the US and the euro area, respectively, in line with our call. It’s even expecting Fed rate cuts at some point next year. US Treasury and German Bund yields are now declining, also as we expected. In the UK, this hasn’t happened just yet, with market’s interest rate expectations still higher vs our forecast. While we do expect an extra hike or two, as economic growth weakens (our projection is more bearish vs consensus) and, we expect, inflation begins to peak in the UK as well (at the turn of the year), we suspect that the market will price out a few UK rate hikes too.

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