How could the UK general election impact the markets?

The upcoming July 4 elections in the UK are pointing towards a potential Labour majority, potentially ending a 14-year Conservative administration marked by Brexit and a cost-of-living crisis.

Labour's campaign is focused on supply-side reforms and cautious fiscal policies, aiming to drive long-term economic growth and stability. Despite this shift, the FTSE 100 index in the UK remains significantly undervalued compared to global stocks, offering attractive dividend yields and diversification opportunities.

Unexpected early election call by Sunak

Prime Minister Rishi Sunak's decision to call an early general election has caught both the public and financial markets off guard. This will be the first July election in the UK since 1945, prompted by rising inflation rates, with Sunak aiming to focus his campaign on economic recovery. However, the Bank of England has warned that a series of global elections, beginning this weekend in France, could destabilize the UK's financial system.

Labour's strong poll lead

Labour holds a lead of over 20% over the Conservatives. The Conservative Party, led by Sunak, has struggled to gain traction, with some of its supporters moving to Nigel Farage's Reform Party. This shift has allowed Labour to maintain a strong double-digit lead in the polls.

Foreign exchange impact of the election

The 2019 UK election saw the Conservatives win an 80-seat majority amid Brexit-related uncertainties, leading to significant volatility in the British pound.

Brexit is no longer a contentious issue, reducing political uncertainty. Labour's more pro-business, center-ground stance is perceived as favorable for UK assets, potentially narrowing the pound's Brexit risk premium. Both major parties are unlikely to propose radical fiscal policy shifts, aiming to avoid market disruptions similar to those caused by Liz Truss in September 2022. Consequently, the election's impact on UK assets may be more influenced by fundamental economic drivers and Bank of England rate decisions.

Key dates and market reactions

Voting will take place on July 4, with results expected by dawn on July 5. Early polls favor Labour, but these predictions are subject to change. The Conservative Party's 11-point lead in the 2017 election resulted in a hung parliament, highlighting the potential for unexpected outcomes.

Market reactions have been muted so far, with sterling reaching June high. However, volatility is anticipated to increase as election day approaches. The proximity of the 2024 UK election to the US elections in November could also heighten market volatility, reminiscent of the 1992 UK election, the only other instance of UK and US elections occurring in the same year.

Potential outcomes

Various election outcomes could influence the GBP and market dynamics:

• Hung Parliament: Labour may need support from the Lib Dems and/or SNP, raising the likelihood of a Scottish referendum. This scenario could weaken economic growth prospects and lead to lower BoE rates, posing a downside risk to GDP in general.
• Narrow Labour Majority: A slim majority could make Labour more reliant on its left wing, potentially leading to more expensive fiscal policies and higher BoE and market rates.
• Conservative Win: Markets generally favor continuity, but a lack of confidence in PM Sunak among Tory MPs could lead to a change in leadership, increasing political uncertainty and market volatility.
• Large Labour Majority: A significant Labour victory could facilitate policy implementation, potentially benefiting GBP. However, BoE policy will be crucial, and expected rate cuts could limit gains.

Economic stability and policy prospects

Despite the political uncertainty, signs indicate that the UK economy is stabilizing after a brief recession last year. Positive trends in forward-looking indicators such as the PMI and consumer confidence, along with declining headline inflation due to easing goods inflation, suggest potential for the BoE to consider rate cuts earlier than the US Federal Reserve.

A stable policy stance under a Labour government could sustain this economic trajectory, with a focus on supply-side reforms and reducing post-Brexit trade barriers. Labour's plans to increase investments in green projects could also support long-term economic growth.

GBP and FTSE 100 future scenarios

While the market has not seen major changes leading up to the election, historical trends indicate that sterling tends to weaken due to election uncertainty. However, the pound has recently strengthened, likely due to the closely aligned economic policies of the major parties, which have mitigated market fears.

Interest rates and inflation remain key considerations. Despite headline inflation being within target, services inflation, which constitutes 80% of the British economy, remains high. A Labour government is unlikely to make significant changes to interest rate policies, although pro-growth initiatives could make inflation more persistent, prompting the BoE to be cautious about rate cuts.

The FTSE 100 may see a slight boost from the election, but the UK's leading share index is more likely to benefit from an improving economic outlook. Inflation has eased back to the Bank of England's 2% target, down from a peak of 11.1% in October 2022. Meanwhile, the UK economy grew by 0.7% in Q1 as the country emerged from a shallow recession.

These factors, along with investor bets on an interest rate cut later this year, have supported the FTSE 100's strong performance in 2024. The index has gained more than 5% so far this year and has broken above the psychologically important 8,000-point mark. The prospect of a period of political stability could facilitate a further rise to the 10,000-point range over the medium to long term. So the election’s impact on currency markets is likely to be muted.

Historical perspective and market trends

Following elections, GBP/USD has historically appreciated by an average of 3.5% within the first 100 days, regardless of the winning party. While markets tend to perceive Conservative victories as more favorable for the economy, Labour Prime Minister Tony Blair's landslide victory in 1997 saw a 4% rally in GBP/USD, demonstrating that a Labour government does not necessarily weaken the pound.

This snap election carries significant implications for the UK and GBP's trajectory in both the short and long term.