The UK election and the EU

Although European equities started 2015 on the back foot amid the so-called “Grexit” worries, the markets have since bounced back. Sentiment has been lifted by speculation that the ECB will unveil a full-scale QE stimulus programme at its January.

One of the hottest topics during this election could be the future of the UK’s position in the EU. The rise of UKIP, an anti-EU party, has focused minds on whether the UK should stay in the European Union. The Conservatives, which has a powerful anti-EU faction, has promised to hold an in-out EU referendum in 2017 if it wins power. However, if it was to join a coalition with UKIP, a potential referendum could be pushed forward. The Labour party has not committed to a referendum on UK EU membership, so this may only be an issue if we see a Tory government or a Tory-led coalition.

This could be the biggest concern for the FX market in the aftermath of the election. Since a referendum is unlikely to be scheduled for a few years, it could lead to a protracted period of weakness for sterling. 

Our concerns for the pound that may arise from the uncertainty around the UK’s EU membership is:

• Its large UK current account leaves it vulnerable to a shift in international sentiment towards the pound and UK debt. Right now the international market is happy to fund the UK’s defi cit, but this may not be the case if it looks like it is going to leave the EU.

• The FTSE 100 is also a major hub for international companies to list. Part of the UK’s attractiveness is its proximity to Europe and membership of the EU. If it leaves the EU this could reduce the desire of foreign fi rms to list in the UK and others could try and move to a different index, which could weigh on UK stock markets.

As we mention above, the Conservatives are traditionally seen as the “pro-business party” and are thus good for UK assets, although this is not always the case for the pound, as you can see above. However, this time around, a Tory government set on an EU referendum could weaken business in the UK and weigh heavily on UK asset prices.

But this does not mean that a Labour victory would trigger a rally for UK assets. Instead, we think that a Conservative/Lib Dem coalition or a Labour/Lib Dem coalition would be the best outcome for UK asset prices. The Lib Dems could keep UK politics fairly centrist which may avoid any lurches to the left or right.

If there is uncertainty around the UK’s EU membership then we may see UK risk premia rise, which could push up UK bond yields. A rise in bond yields, even from historic lows, is unlikely to benefi t the pound, which would also come under pressure from uncertainty about the UK’s position in Europe.