It has been a volatile start to the week for the Great British Krona.
Cable ran up to $1.52, then hit a brick wall presumably as the market digested Sunday’s YouGov opinion poll, which showed the lead of the Conservative Party down to just four points. That would, of course, not be enough for a working majority.
But just how seriously should these polls be taken? Not very, is the answer from Nomura.
In a report published on Monday morning, the bank says that in spite of the recent shifts in the polls, the 2010 general election is likely to result in a working majority for the Conservative party and that will trigger a sterling and gilt market rally.
The reason should be familiar to Westminster watchers.
- The UK’s first-past-the-post system means that the overall share of the national vote does not translate directly into share of seats (indeed, the party with the largest share of the popular vote will not even necessarily end up with the largest number of seats).
- The UK’s electoral history tells us that the 2010 election will most likely be won and lost in a relatively small number of marginal constituencies that require a significantly lower swing than the national average to change hands.
In common with most political commentators, we expect the Conservative Party to outperform in a significant number of marginal seats that they are widely reported to be targeting. If this proves to be the case, it follows that the Conservatives could be returned to power with a simple majority on the basis of a national lead over Labour of somewhat less than seven percentage points.
That said, it will not be plain sailing for the GBK even if the Tory party manages to secure a working majority, according to Nomura.
In conclusion, we think sterling is likely to remain on a difficult road in the months ahead. Sterling may enjoy a post-election bounce if a clear winner emerges from the election, but this gain may fade once the difficult task of governing begins. With the UK at the limits of its fiscal flexibility, some belt-tightening is clearly in store. We think this is likely to remain a significant headwind for sterling for some time to come.
However, it thinks gilts might fare rather better.
The central scenario from our political analyst remains one where the most likely outcome is a workable Conservative majority and no doubt, given a fresh mandate and a clear period to allow some initial pain (in terms of policy measures), we could see a fairly strong positive initial reaction from debt markets to such news, and likewise this would lower the perceived risk premium needed in the curve and should allow something of a short-run flattening episode. The combination of debt market performance, along with a likely positive currency response, could make sterling-denominated assets the strongest performer of Q2 compared with other developed markets.
Now, that might sound rather odd, given the current budget plan suggests the UK government will have to issue £213bn of debt in 2010/11 and there is no QE to mop up supply.
But Nomura is bullish:
However, on the presumption a credible and relatively severe austerity plan is announced post election, there would likely be minimal ratings risk (as the agencies would be likely to give a stay of execution on any potential downgrade) and as such one of the main risks to sustaining demand for gilts would be removed. Equally, there is the potential positive fiscal effect from the austerity measures, which our economists estimate at around £25bn. This could reduce issuance needs by around 10% in FY 10/11, but would also be presented with potential further positive surprises if asset sales were undertaken (government holdings in Lloyds Bank have a current market value of just above £14bn and around £18bn in RBS).
The bottom line is that if there is little impact on issuance needs, the positive effects of a stable conservative government would likely fade. If a credible plan cuts 10% or more off the issuance schedule in FY 10/11, we would expect a more sustained outperformance from gilts vs their peers and a flatter term structure to prevail.
As for the stock market, well Nomura thinks that will sail on regardless because of its growing internationalisation (and the translational effect of weak sterling on corporate earnings):
We think that it will be muted for the following reasons: interest rate policy is in the hands of the Bank of England, not the politicians, and none of the major parties have any intention of altering the current arrangements; 76% of sales of the FTSE 100 are now sourced overseas; and stock market performance is more highly correlated internationally.
We are all FX traders now.
Related links:
Sterling is definitely Tory – FT Alphaville
The UK’s heading one (AA) way, Citi says – FT Alphaville
A frugal policy is the better solution - FT
Vampire squid really quite confident on sterling – FT Alphaville