maandag 5 juni 2017

The Market Has Zero Concerns About Thursday's UK Election

Having learned its lesson that both an "unexpected" result (in the case of Brexit and Trump), and a "priced in", favorable election outcome both lead to higher risk prices, the market no longer even pretends to be nervous about the outcome of this Thursday's general election in the UK. To be sure, it has good reason for that: despite fluctuating polls, virtually every analyst's base case for this election remains a Conservative majority large enough to allow for the necessary compromises to deliver an orderly "hard Brexit" with a transition period lasting 1-2y. However, as shown in the chart below, a recent narrowing of the polls poses risks to this scenario...


In terms of election outcome, the extent of the Conservative majority matters most for Brexit risks; a less than 60 seats increases the risks of the UK walking away from Brexit negotiations according to BofA. On the other hand, a larger conservative majority increases the likelihood of securing transitional arrangements and fully implementing Brexit; a larger majority should enable Prime Minister May increased flexibility to compromise with the EU-27, despite opposition from the Eurosceptics within her own party. Alternatively, while a Labour-led coalition or outright victory has the potential to lead to a softer Brexit, analysts are worried about growth risks posed by some of the policies put forward in their agenda. Not everyone is "worried" however, and certainly not the market. In an analysis released today, Goldman asks "what does the market appear to be pricing in the way of moves in UK asset prices around the event?"
The answer: "not much, in line with depressed vol across assets." More: 1m GBP/US$, FTSE 100 and 10-year rates implied vols are at their 28th, 17th and 0th percentiles since the start of 2016, respectively. While short-dated GBP implied volatility has increased in the past month, it still remains far below any other peaks over the past 18 months, when Brexit began to come more into focus in the summer of last year. There has also been no spike in 1-month vol as we have come closer to the event, which is unusual when compared with previous political events in the past year. The collapse in vol ahead Thursday's "event risk" is shown below...


Of course, the market is reacting logically: having learned the hard way that anticipating volatility ahead of major political events only leads to losses, few bother to buy event protection any more. On the other hand, Thursday will also bring the ECB's "hawkish" announcement and Comey's testimony, both of which carry some potential for surprise. With vol trading at record lows, some heging may not be the worst idea.
# Finally, for those the skeptics out there, here are Capital Economics' John Higgins & Paul Hollingsworth, explaining how markets could react if the Conservatives do not win: Although bookmakers’ odds still suggest that the Conservative Party will win an outright majority in Thursday’s UK General Election, the odds on a hung parliament have shortened considerably in the last few weeks. Indeed, the implied probability of this outcome recently rose to nearly 20%. While there hasn’t been a big reaction in the financial markets, there clearly could be one if the probability became reality. In the short run, we suspect that a hung parliament would be negative for sterling. When the election was called on 18th April, the polls pointed to a landslide victory for the Conservative Party. This boosted the UK’s currency, as investors assumed that such an outcome would lead to a “smoother” Brexit. In the event of a hung parliament, negotiations would probably be “bumpier” and political uncertainty would rise. Although some investors might envisage a softer Brexit, there isn’t much to choose between the Conservative Party and the main opposition Labour Party when it comes to their views on the UK’s departure from the EU. The upshot is that sterling might falter, indeed, the boost the currency received after the election was called has already faded, as the possibility of a hung parliament has grown. (See Chart 1)...


Meanwhile, sterling weakness in the aftermath of a hung parliament could conceivably boost the UK stock market, as it did after the vote for Brexit. But we are not convinced that equity prices would continue to rise, given the political uncertainty. In our view, the main beneficiary from such uncertainty might be UK government bonds. It might not be long, though, before we started to see a different reaction in the markets. After all, if a hung parliament resulted in a workable minority Labour government, there could be a shift towards much looser fiscal policy. This would probably lead to a renewed rise in Gilt yields, which have already fallen to very low levels, by driving up expectations for interest rates. Such a mix of looser fiscal and tighter monetary policy could also benefit sterling. A renewed rise in the currency, coupled with Labour’s plans for much higher corporation tax, would, however, be bad news for UK equities....

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