The UK government: Not so strong and stable - J.P. Morgan Asset Management

The UK government: Not so strong and stable

Contributors Stephanie Flanders, Global Markets Insights Strategy Team

Not the outcome markets expected

This is not the outcome the financial markets-still less Theresa May-were expecting. Instead of the larger Conservative majority the prime minister was seeking, the UK has a hung parliament, with no single party in overall control, days before the negotiations for Brexit were due to start on 19 June. May's party will punish her sooner or later.

For financial markets, the lesson is not so obvious. Investors do not like uncertainty, to be sure, or the likely prospect of yet another general election in due course. But nor did they favour the prospect of a hard Brexit, with the UK out of the single market and out of the EU customs union, as May had promised.

The impact on currency and markets

The pound fell nearly 2% against the dollar overnight, after the exit poll that was published when voting ended unexpectedly indicated a hung parliament. The FTSE All Share gained when the market opened. A weak pound translates into higher earnings in the short term for many of the big FTSE 100 companies that dominate the FTSE All Share, which earn most of their profits overseas. The mid-caps (FTSE 250) index weakened slightly.

Currency weakness has generally supported the main equity index over the past year, and we may well see that relationship hold once again in the weeks ahead. However, UK equities could continue to underperform the other major developed markets, especially the eurozone. The MSCI Eurozone Index has risen nearly 20% since the start of the year, roughly twice as much as the FTSE All Share in dollar terms.

We have seen days of uncertainty about the future shape of the government before, following the May 2010 election, when it took nearly a week for the Conservatives to form a ruling coalition. Then, the financial markets were remarkably calm. But that was in the shadow of the global financial crisis, when the eurozone was in turmoil. Today, the mood across the Channel is brightening by the month, while the uncertainty hanging over the UK's future is both profound and entirely self-inflicted. 

The UK was one of few economies to see its growth forecast cut in the latest estimates from the OECD. The same report also showed it to be the only major developed economy that will significantly tighten fiscal policy over the next two years. Politically and economically, it sticks out like a sore thumb.

Investment implications

The issues that matter most for investors in the UK market are the pace and shape of Brexit, the short-term stance on fiscal and monetary policy and the underlying strength of the UK economy. The short-term prospects for the economy and monetary policy have not changed with this surprising result. But the UK's future policy on Brexit-and potentially much else-now looks much more uncertain. For investors, the big message is: watch this space.

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