The Election’s Economic Elephant in the Room

A guest post today from the excellent Michael Magnay, of Kleinwort Benson’s Private Wealth Management team who points out the almost total lack of transparency that any of the political parties have had about the disastrous state of the UK’s public finances.

1) NONE OF THE ABOVE

Oh dear. The UK public have had their say and the answer seems to be “None of the Above”. Together Labour and the Lib Dems do not have a majority, and the Conservatives and their traditional Irish allies also do not have a majority. Total left-of-centre MPs looks likely to be 330, total right-of-centre MPs looks likely to be 315, with 4 Sinn Fein who traditionally do not turn up and 1 Speaker. This is a very messy and unfortunate result for £ financial markets.

Gordon Brown as sitting Prime Minister has first go at trying to establish a majority in Parliament. This could be achieved by entering into a formal coalition with the Lib Dems, with 2 or 3 Cabinet posts (Vince Cable still has a shot at being Chancellor), and a promise of a referendum on PR for future elections within a short space of time. Some carrots to the Scottish and Welsh Nationalists in the form of protection against spending cuts would probably ensure their support and in a crisis he could rely on support from the Green MP and the SDLP MP. Thus a left-of-centre majority could be put together, but the bargaining power of the small parties would massively complicate the ability to cut government spending meaningfully. It is likely that in this scenario that Gordon Brown would offer to step down at some convenient point – he does not come across as the sort of leader who would enjoy having to keep many different interest groups sweet, and almost certainly the Lib Dems would demand a different PM. This is a complicated but plausible scenario, and would not be welcomed by the gilt and foreign exchange markets.

For the Conservatives the result means that if they wish to hold power they would have to find some accommodation with the Lib Dems at least to support a package of measures for a first Queen’s Speech. To date they have given little indication of wishing to do that but reality may prevail. There is however no chance that they would offer a referendum on PR, so something quite powerful would need to be offered to the Lib Dems instead. It should be clear to all involved though that at the first opportunity the Conservatives would look to have another election (which only they could afford) to achieve a majority, so this does not look like a stable solution. It would almost certainly cramp their ability to reduce the deficit quickly.

The Lib Dems are potentially caught between a rock and a hard place. The first solution could easily be characterised as a Club of Losers desperately doing deals in order to hang on to power at any cost – if the markets rebelled at the slow pace of deficit reduction it could put back the idea of 3 party politics and coalitions for a long time to come. Equally they have little bargaining power, they have to appear to ready to deal and the Conservatives may not have to offer them very much , so that they are a very junior partner in any alliance to be discarded as soon as is convenient.

2) THE ELEPHANT IN THE ROOM

A common feature of the campaigns of all 3 major political parties was the total lack of transparency with regard to telling the public the true state of the public finances and what will have to be done to put them right. Indeed if one was only to go by the fiscal tightening measures actually detailed in any of the manifestos, then by the end of the life of next Parliament, Britain would have approximately the same deficit and debt position as Greece, which in the period since the manifestoes came out has effectively gone bankrupt. This was the elephant in the room throughout the campaign, and the politicians resolutely refused to turn round and look at it. This could be an issue because there is not a mandate from the election to take the painful action that will be required. At its simplest , the current level of public spending was envisaged for an economy that was at least 10% larger than it is today. This “structural deficit” is thus of the order of £70bn, the rest of the deficit can be characterised as “cyclical” and can be expected to reduce naturally as growth returns to the economy – the problem though is that the very act of reducing the structural deficit (which could be achieved for example by raising the basic rate of income tax from 20% to 30% and by raising VAT from 17.5% to 24%) is likely to reduce economic growth and so make the cyclical deficit much worse.

A new Prime Minister can be expected to come out quite quickly with news that the public finances in a much worse condition than has been previously admitted – this can be painlessly achieved by adjusting the future expected economic growth rates, and blaming Gordon Brown for this terrible inheritance. The financial markets will not be too surprised, but it is now very important, following the Greek crisis and its contagious effects on markets in Portugal, Ireland and Spain, that there is a seriousness of intent and a credibly detailed plan to deal with the deficit brought forward fairly quickly. The ratings agencies have previously indicated that they have been holding off a more negative assessment of the UK’s credit rating pending the election, and any new government’s plans.

3) LAST NIGHT IN THE US MARKETS

Globally equity markets have in recent week been spooked by developments in the eurozone, and last night saw the Dow Jones Index fall 600 points in 3 minutes for no apparent reason , before regaining all the ground in the next 5 minutes. This highlights the continued relative lack of liquidity in markets and febrile sentiment despite the huge rally of the last 14 months. Such market skittishness is not a great backdrop to the uncertainties now within the UK political system.

We continue to monitor closely the impact on markets. Despite the marked sell-off overnight in the US the UK market has been resilient and is currently down 0.6% at 5229. GBP /USD has weakened markedly in the past few days as macro views have been expressed through the most liquid medium.

Equities continue to look underowned relative to bonds as they offer a better hedge against sovereign credit risk and longer term inflation. The uncertainty we are currently seeing provides opportunity for those prepared to take a degree of measured risk, however patience is a virtue. The European market is inexpensive on 10.5x next year and we continue to forecast strong growth in both the US and Asia.

Michael can be contacted by phone at: +44 (0) 1223 454 561