UK election boils down to one issue for markets

April 15, 2010

JaneFoleyJane Foley is research director at The opinions expressed are her own. –

Whether the financial markets will view the outcome of the UK general election as a positive or negative depends almost entirely on one issue: the budget deficit.

According to The Economist, the UK’s budget deficit will balloon to 13.5 percent of GDP in 2010. To give this some perspective, The Economist estimates that the Greek deficit will be a somewhat more moderate 9.5 percent of GDP this year.

Fuelled by recession, last year’s UK government borrowing was the largest ever in peace time.  The deterioration in the budget caused S&P to warn last May that the UK’s debt rating outlook has been revised to negative from stable.

The prospect of a sovereign downgrade would seriously increase the likelihood the UK would suffer a funding crisis.

In other words a lower debt rating would reduce investor interest in UK debt auctions and send yields higher and demand for sterling lower.  In turn higher yields would increase the cost of issuing bonds and divert more taxpayer money into servicing the debt and away from public services.

While there is probably no imminent risk of a credit rating downgrade in the UK, it is clear that budget reform is necessary to kick this threat into touch.

All political parties are aware of the need to rein in the deficit but the Labour party has taken the stance that tackling the budget deficit must be delayed to avert the risk that too much austerity too soon could tip the economy back into recession.  This has made the Conservative opposition the more market friendly political party.

The huge proportions of the UK budget deficit mean that the focus on spending cuts and taxes rises is more pronounced that usual in the build up to this year’s general election.  The combination of deficit worries and slow growth have been instrumental in driving sterling lower by 22% vs the USD and 22% vs the EUR since the end of 2007.

Bearing in mind that there is so much bad news already in the price and the market is positioned very short of sterling, there is the possibility that investors would cover these positions if the outlook for the budget deficit improves.

The first potential positive trigger for the pound would be if the Tory party were to win a outright majority on May 6.  While opinion polls continue to suggest this may be difficult for the Conservative party, interestingly the bookies odds point to a greater possibility of this outcome.

The other support for sterling would be better than expected economic growth which would increase the tax income into the treasury’s coffers and reduce the borrowing requirement.

While it is likely that growth will be fairly lacklustre this year, the outlook on the economy has been improving.  Purchasing manager’s surveys continue to indicate economic expansion, the housing market is maintaining a modest (if erratic) recovery and both February production and export data were better than expected.

The combination of improving growth coupled with a Tory election victory has the potential to push sterling sharply higher and strengthen the possibility that that sterling may have already seen its lows for the year vs both the dollar and the euro.

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Cable fundamentals imply more downside for the unit irrespective of current market positioning.
A weak, near aneamic GDP rate,the high probability of further QE action, and an as yet unresolved, unfunded and worsening deficit/fiscal situation would cast more than reasonable doubt on any optimistic near to medium term outlook for the GBP.
The continuing deterioration of the Euro will also tend to drag cable lower and I would estimate this particular currency at parity with the US dollar in the medium term.
Technicals also support the negative cable view on the yearly, monthly and weekly period charts, with only daily and lesser timeframes registering a shallow pullback.
Have I missed something?

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