UK Election Preview: What about the market reaction?

The UK election looks to be the closest fought in decades as Labour tries to wrestle back power from a Conservative government that in its five years in power has struggled to win over the electorate. The coalition government, comprising the Conservative Party and the Liberal Democrats, have implemented a program of austerity and reforms aimed at deficit reduction, reducing the size of the public sector while incentivising private sector job creation and growth.

From this perspective, their efforts have been rewarded. The deficit has fallen from more than 10% of GDP in 2010 to 5% today, 2.3 million private sector jobs have been created, easily covering the 500,000 lost in the public sector, and the UK was the fastest growing major developed economy in 2014.

However, the reputation of the Conservatives of being ruthless and uncompassionate while favouring the wealthy has only grown in the last five years as real incomes have fallen, benefits cut and the upper rate of tax reduced from 50% to 45%. Inequality has been a key issue throughout the last few years, with people suggesting the gap between the rich and the poor has grown.

That said, the coalition government would claim that the top 1% now contribute almost a third of all income tax, much more than under the previous government, while the lowest earners now pay less as a result of the lower tax threshold being lifted.

Controversial policy decisions such as the so-called “bedroom tax” and the increase in tuition fees – not to mention the number of people now on unsecure zero-hours contracts – hasn’t helped the popularity of the Conservatives, while the commitment to a referendum on EU membership by the end of 2017 has created a lot of uncertainty among many businesses that conduct a significant amount of trade as a result of the beneficial trade agreements.

The result of all of this is that, despite the economy performing strongly, unemployment being low at 5.6%, and the number of those employed being at a record high, the Conservatives may not even win the election, let alone secure an overall majority.

What is the likely outcome from the voting?

The polls throughout the election campaign have barely changed, with the Conservatives and Labour occupying about a third of the vote each and the remaining parties the final third.

This means no party is likely to get enough of the votes to rule by majority, resulting in a hung parliament. This leaves three possible options on the table; a coalition government, a confidence and supply agreement between two or more parties or a minority government.

A coalition would probably offer the most stable government, although Ed Miliband has explicitly stated that he would not go into coalition with anyone as it would mean giving up parts of the Labour manifesto. The chances are, this is just a ploy to win back some votes in Scotland from the SNP as people vote tactically to prevent another Conservative-led coalition.

The latest polls suggest that the Conservatives will win the most seats but will struggle to form a majority government, although a Conservative, UKIP and Lib Dem coalition could be enough to form a majority. If they’re desperate enough to prevent Labour returning to power, they may be forced to consider this.

The consensus view is that the “anti-Conservative” feeling is so great in Westminster that a Labour minority government – led by Ed Miliband as Prime Minister – is most likely. A minority rule would prove extremely challenging over the five year term and I therefore think, under these circumstances, we’d see a change of heart from Miliband and a confidence and supply agreement with the Scottish National Party would be agreed.

What about the market reaction?

So far, the market reaction has been fairly muted. The pound has been weak against the US dollar since the middle of last year but in that same time, it has performed well against a basket of currencies overall.

This, along with the strong rally in the dollar, suggests that weakness in cable is not being driven by election uncertainty weighing on the pound. If we need any more evidence of this, just compare the yield spread between then US 10 year Treasury and the UK 10 year Gilt with cable over the last nine months. This shows that changes in interest rate expectations is what’s driving cable, not the election.

That doesn’t mean we won’t see election uncertainty weighing on the pound in the final days, although there is no real evidence of that yet.

Once the election results are out I would expect to see more of a reaction because the result will have a direct impact on the economic outlook and therefore interest rates. For example, a Conservative majority or Conservative-led coalition is seen as being good for the economy, for now, as it would mean a continuation of the strong recovery that has prompted talk of interest rate hikes from the Bank of England. This should therefore be sterling positive.

Labour on the other hand are seen as being less business friendly and would bring higher taxes on the wealthy, more spending and therefore potentially higher interest rates. This is seen as being negative for the economy and investment and could therefore weigh on growth this year, pushing back interest rate expectations and weighing on the pound.

The FTSE is unlikely to be impacted much by the uncertainty ahead of the election or its outcome. This is because, despite being a UK index and benefiting from low interest rates, it is made up of large multi-national companies and has a lot more exposure to countries like China. This can be seen by the correlation between the FTSE and the 10 year Gilt yield, which isn’t very strong.

What do the charts tell us?

GBPUSD

The cable chart is looking quite bullish right now, having rallied strongly over the last month. The pair broke above the 89-day simple moving average and has since provided support on the pullback which is a very bullish signal. The 89-DMA is not an overly common moving average to use but it is a Fibonacci number and has been a reliable support and resistance level in the past, as it has now, so I see no reason to doubt it.

With the pair looking bullish, the next obvious resistance for me is 29 April highs around 1.55. If this can be broken, 1.5550 – 1.5570 comes into play as this area marks 26 February highs, 14 November – 21 December support and 38.2% Fibonacci retracement level – 15 July 2014 highs to 13 April lows.

While this may mark the end of the correction and continuation of dollar strength, I think we could see it move further towards 1.5875. This is 15 October lows and the 50% retracement of the above move. The 233 DMA (another fib number that has proven reliable on this chart) could also act to cap a further upside move.

EURGBP

The pair is facing heavy resistance following a strong rally over the last week or so. The descending trend line which had previously offered support prior to the pair breaking below on 22 January is now providing strong resistance. Combined with the 20-week SMA and the 100-day SMA, this may prove a tough level to break. It is worth pointing out that while these have provided support and resistance on numerous occasions, they haven’t been reliable as of late.

I am not convinced this level will hold, especially as the pair recently broke above the neckline of an inverse head and shoulders that formed between the middle of January and the end of April. A break of this kind offers two potential price projections, taking the size of the shoulder and the head and projecting them above the breakout point. This gives us two levels, around 0.75 and 0.7750, the latter of which acted as support between October and the end of the year.

If the current resistance level holds, it could lead to the formation of a double top with the neckline being yesterday’s lows. A break of this would be a strong bearish signal offering a possible price projection, based on the size of the formation, of around 0.7215.