Drifting towards constitutional chaos

Typically markets give little consideration to political events until they are right on top of them, so it may now be appropriate to give some thought to the possible outcomes of the UK general election. Nationally the poll ratings for Conservative and Labour have been very steady for well over a year now, though ibn Scotland Labour have been losing significant numbers of voters to the SNP. A parliament of 650 MPs made up of approximately 280 Conservative, 270 Labour, 30 Lib Dem, 50 SNP and 20 other (15 Unionist and UKIP on the right, 5 Green and Plaid Cymru on the left) is close to that implied by the political betting markets and current polls, and would leave the UK political scene in a very uncertain state.

This would leave the traditional right-of-centre parties at 295, the Labour, nationalist and Green parties at 325 and the Lib Dems in the centre with 30. The implication would be that the only two-party coalition majority that could get close to a majority would be a Labour/SNP coalition; however the price of such a coalition would very likely be the break-up of the UK itself. Alex Salmond would be the SNP leader in Westminster and he has shown himself to be a very effective political operator in the coalition politics of Holyrood.

Sadly no other outcome looks good for markets either:

  • Traditionally the best outcome for markets would be a majority for a stable right-of-centre government. A Conservative majority, while looking extremely unlikely at the current juncture would however be one fraught with political and constitutional risk as the Conservative manifesto will commit to holding a referendum in the UK’s continued membership of the EU. The uncertainty that such a referendum would engender in the minds of business leaders would be very negative for investment in the UK, and a vote to withdraw is likely to be viewed very negatively by the UK financial markets.
  • A continuation of the present Conservative/Lib Dem coalition, is also not likely on the current poll ratings. It would however be likely to feed continued Scottish disgruntlement, where neither of the UK governing parties is likely to have much representation north of the border. Further demands for more powers for the Scottish parliament are also likely to be met with stronger rhetoric for English-only MPs deciding English matters, bringing the very concept of the Union under deeper strain.
  • A minority Conservative government would find it very difficult to get its economic and budget policies through parliament, where a combination of Labour, Lib-Dem and SNP votes would block most of their plans.
  • A Labour/Lib Dem coalition looks unlikely to have enough support within parliament by itself, it would be dependent upon support from the SNP to pass legislation and that support would come at a price. The same would be true for a minority Labour government.
  • A Labour majority would not be welcomed by financial markets as Ed Miliband is perceived as one of the most anti-business Labour leaders since Michael Foot.

Weak government and constitutional uncertainty look to be the only sure thing to come out of the forthcoming election. Weakness in the euro is the current flavour of the month in the currency markets, following the ECB’s decision to (finally) implement QE. By the time May is here, it may be they are seeking a new trend – weak sterling on the back of political uncertainty could well be that new trend.

2015 – a double election year?

2015 looks set to be a particularly political year, with the possibility of there being two general elections looking increasingly plausible. In the last six months, the strong performance of UKIP in the European elections and the SNP in the referendum vote, have seen UK politics move from the three party affair thrown up by the 2010 election (itself a radical departure from the two party politics naturally favoured by a first-past-the post system) to one where the fortunes of five different parties need to be considered to determine the final outcome of the 2015 election. One could add the Green party as a sixth, given their existing one seat and recent improvement in the polls.

In a constituency system with just one vote, a candidate merely needs more votes than any other candidate, and does not need the support anything close to half the electorate to win. In a 4-way competition, just 25.1% could theoretically be sufficient to win the seat. Thus the impact of new parties drawing votes from existing parties can make predicting the winner of any individual constituency incredibly difficult.

UKIP are currently showing at 17% in the opinion polls, with their support being drawn approximately ¾ from former Conservative voters and ¼ from former Labour voters. This could be enough to win a handful of seats, but the more important national impact could be the split in the Conservative vote allowing Labour to win some individual constituencies where they would not otherwise expect to have sufficient support.

The interest and passion displayed by the Scottish electorate in the independence referendum has continued since then and the SNP has in recent polls been drawing huge support from former Labour voters in Scotland, where Labour currently holds 41 seats, which are now under threat.

Support for the Liberal Democrats collapsed from the 26% achieved in 2010, from the moment they reversed stance on student fees in the initial Coalition Agreement. Their 7% showing currently in the opinion polls is very poor but their MPs tend to have built large local support bases in their constituencies and they are likely to win more seats than their national support would suggest.

The two major parties have not between them garnered the support of more than 2/3 of the electorate since the last election campaign (in 1945 they took 95% of the vote, but have been in decline since then). The current distribution of constituencies favours Labour, who hold many inner city constituencies where the size of the electorate has shrunk over the years, whereas Conservative constituencies are more concentrated in the suburbs where electorates have been rising.  Until recently, most analysts believed that Labour could win a parliamentary majority with just 35% of the national vote, whereas the Conservatives needed to win about 40%.  The recent rise of UKIP and the SNP probably means that these estimates need to be increased.

On current YouGov forecasts, not only will neither Conservatives nor Labour win a majority of seats, a coalition of either party with the Liberal Democrats will also not produce a parliamentary majority. The most likely outcome of the May 2015 election is thus a second election in October/November next year.

Opinion polls do fluctuate and there are still almost six months until the poll that matters, but the electoral arithmetic against a stable outcome looks difficult to overcome. For UK financial markets this may be troublesome in 2015.  This was always likely to be the case as a Conservative-led government would be committed to holding a referendum on EU membership in 2017, which would generate huge uncertainty in the minds of business with regard to investment in the UK, whilst a Labour-led government would be led by Ed Miliband, who would be seen as the most left-wing and anti-business Prime Minister that the UK has seen.

It is difficult to work out what a good election outcome would be for the financial markets.

The German dilemma

Since the drama of the Italian election in the spring, European politics have been remarkably quiet.  This has been by design – the countries who would like Germany to provide money or ease policy to support their beleaguered economies have understood that it is very important not to scare the German voters ahead of their general election on September 22.  There was a fear that “bailout fatigue” amongst Germany’s electorate might force the politicians to make promises not to provide further support to weaker economies.

In two senses, the result is not in doubt – (i) Mrs Merkel seems sure to remain as Chancellor following the election, as her party is odds on to have the largest share of the votes and (ii) in that event, she will have to lead a coalition to form a government.  What is uncertain is that this coalition will either be a continuation of the current coalition (of Merkel’s centre-right Christian Democrats with the Free Democrats should they reach the 5% threshold of the total vote required to get any seats in the Bundestag), or, if they don’t, there will be a “grand” coalition with the Social Democrats, the large centre-left party.

Whatever the shape of the resulting coalition, the next German government faces a huge dilemma between its two major policy objectives.  It can choose to do all that it can to keep the Euro intact, which will achieve its foreign policy objective of being at the heart of an ever-closer European Union, but at the expense of its economic policy objectives of low and stable inflation and balanced budgets.  Or it can choose to insist that Europe’s economic policies reflect those of Germany and watch as the rest of Europe suffers from economic stagnation until the option of withdrawing from the Euro becomes impossible to resist for some, threatening the survival of the Euro.

To achieve both of Germany’s key policy objectives, the optimal solution is a continuation of the current German stance where they provide the minimum in bail-outs to prevent a default,  in return for a commitment to continued austerity at an agreed pace.  This achieves their dual goals of keeping the Eurozone together, whilst maintaining a German –style attitude to fiscal policy and thus low inflation and a sound currency.  It delivers the “stability” that is so prized by German politicians.  However, this is an inherently risky policy for most of the rest of Europe, delivering a graveyard type of stability.  It will ensure near zero growth, high unemployment and weak banking systems across the Eurozone, for a long time to come.  It is eerily similar to the policy adopted by Japan which led to two decades of stagnation.

To escape this stagnation, countries in the Eurozone have three options: (i) leave the eurozone and repay their euro-denominated debt in their new (and devalued) currency – this would dramatically improve their trade competitiveness and reduce their national debt, but badly damage their relationships with their European neighbours; (ii) persuade the ECB to engage in Quantitative Easing in an effort to create inflation, which would reduce the real value of their debts and might also encourage some growth; or (iii) construct the necessary  banking, fiscal and political unions to go alongside and support the existing monetary union.  At an aggregate level the economy of the Eurozone does not have great budget and trade deficits.  It is only at a national level that the problems appear, which implies that a deep and real economic union between the countries can be successful.

Of these three options, the first is seen as suicidal by incumbent politicians, not only for their prospects for domestic re-election but also for their chances of any future European roles in Brussels.  The second is hard to imagine, since it would require both the ECB and the Germans to support a higher inflation objective.  The third is very complicated to achieve – in 2011 the German Constitutional Court pronounced that the German constitution does not permit further significant political integration without a German referendum.  It would also probably require referenda in several other Eurozone states.  This is though the most logical solution to the Eurozone’s problems.

The banking systems across the Eurozone remain very weak, with the OECD recently estimating that since the crisis began, Eurozone banks have reduced the size of their balance sheets by €2.8tr but have a further €3.0tr still to go, from total balance sheets of approximately €32tr. The banks, particularly in the peripheral countries are in no position to support growth by increasing their lending.  The outlook for economic growth in the Eurozone is thus very restrained, meaning that unemployment will remain very high and that governments will continue to struggle to deliver deficit reductions.

The implications for investors are that Eurozone growth will be very sluggish (even though in the short term growth may be improving), and will remain so as long as Germany’s preferred policy approach continues to hold, since no further fiscal or monetary stimulus will be supplied to the eurozone economy.  We remain very cautious on European equities, which do appear cheap, but that cheapness is concentrated in banking shares and in the markets of the peripheral economies whose prospects remain very challenging.

Democracy – the antidote to Eurozone austerity

Over the last twelve months of Eurozone crisis, the politicians in Europe have in the main been talking to each other rather than their electorates. In fact the conversations have involved Northern Europeans (mostly from Germany) telling Southern Europeans to slash government spending and find ways to collect more tax revenues and the Southern Europeans promising very solemnly that they have always intended to and will do so just as soon as they receive some extra money from the Northern Europeans. The voters have never been asked their opinion either in the North as to whether they want to commit funds to support those in the South, or in the South as to whether they want to go through with the austerity measures their politicians have agreed to. Over the next 18 months there are important votes in France, Greece, Holland and Germany, when the politicians will be courting votes and saying things that are odds with current policy settings.

It is said that in the French presidential elections, in the first round the French vote with their hearts and in the second round with their heads. Well, 30% of the electorate voted for the extreme left or the extreme right in the first round; both reject entirely the idea of deeper European integration and the economic policy of austerity. Further, the centrepiece of Francois Hollande’s platform is the rewriting of the fiscal compact set out in the new treaty to pursue a much more aggressive growth strategy and greater powers to the ECB to lend directly to countries. In this he is on a collision course with Angela Merkel and impact is likely to occur very soon after the May 6 run-off election. The received wisdom is that he will not seek dramatic change to what has already been agreed, and will be satisfied with language that has an aspiration for greater growth without meaningful measures – this would probably the best he would get from Merkel and Germany. The key though is that a clear majority of the French electorate rejected the current policies of austerity.

May 6 is also the date of the Greek general election. The technocrat Papademos who was put into power as the head of a coalition government of the 4 major parties in order to agree the terms and conditions of the Greek bailout, has completed his job and is stepping back to allow normal politics to resume. Northern Europe insisted that all 4 parties in the coalition individually signed up to the terms and conditions of the bailout, in order to prevent any backsliding after the agreement, but there are already problems. Recent polls indicate that 67% of Greeks want to stay in the euro but don’t want the austerity, which can be interpreted as wishful thinking, economic ignorance or that their politicians are allowing them to believe that such a choice exists. It is not clear that those 4 parties would command 50% of the seats in the new parliament, even if they could be persuaded. Already Venizelos, the head of the Socialist party has been floating the idea of Greece going back to the drachma as an alternative to austerity.

The Dutch too are struggling despite being seen as part of the Northern European bloc. The coalition government fell over the weekend because the far right party refused to accept the austerity measures necessary for the Netherlands to get their budget deficit in line with the Eurozone targets. An election now looks likely in Holland.

Once these elections are settled, attention will begin to shift to Germany’s election in September 2013. Here though the politics is reversed, what is popular with the Germans is the notion that the rest of Europe should engage in the austerity necessary to get their public finances in order as Germany has had to earlier this century, so that no further calls on the German purse are made from bankrupt Eurozone nations.

Exposure to the votes of their peoples is going to cause politicians to say and do things that make continued agreement on austerity and bailouts increasingly hard to do.