UK Watch – Hung parliament raises Brexit risks

by: Nick Kounis , Aline Schuiling , Georgette Boele

In this publication: UK elections lead to hung parliament, with Conservatives losing their majority.  The Conservatives will now likely need to rely on support from the DUP,  meaning an unstable UK government will conduct the negotiations for Brexit. Brexit negotiation process looks to have become even more complex with a greater risk now of a ‘no-deal’ scenario. Further downside for sterling if markets price in a ‘no-deal’ outcome.

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Hung parliament, with Conservative-DUP tie up likely

The UK elections resulted in a hung parliament, with the Conservative party losing its majority. With most of the results in, the Conservative party looks to have taken 319 seats in the 650-seat parliament. They would officially need 326 seats to form a majority government. In practical terms, they may need somewhat less (322) as the Sinn Fein MPs (7) will likely not take up their seats.

The Labour party (261) took many more seats than expected, but have no chance of forming a government. Their potential coalition partner, the SNP, lost seats (35), while the Liberal Democrats (12) have ruled out entering a coalition or arrangement with any other party.

The Conservatives will now likely need to rely on support from the Democratic Unionist Party (DUP – with 10 seats) in order to govern. This could be achieved via either a formal coalition, or by forming a minority government and relying on the DUP on a vote-by-vote basis.

Unstable government negotiating Brexit

Either way, this would mean than an unstable UK government will conduct the negotiations for Brexit, which officially begin in 11 days, though a delay is quite possible. For instance, the government could easily collapse if even a relatively small number of MPs vote against the government. The DUP is pro-Brexit, but is in favour of a friction-less boarder between the Republic of Ireland and Northern Ireland, which would make immigration from the EU to the UK difficult to control.

At the same time, Conservative MPs that are in favour of either a soft Brexit or a hard Brexit could make life difficult for the government. So any future Conservative (-led) government would need to walk a fine line in those negotiations. There is also a significant risk that new elections will be necessary at some point down the line.

Brexit negotiations more complex, ‘no-deal’ risk rises

Any Brexit deal would need to pass through parliament, and therefore, the government would need to have all the pro-Brexit Conservatives MPs on its side as well as the DUP. From that perspective, a hard-Brexit deal (which significantly restricts trade and the free-movement of people) may have become less likely. However, the alternative may not be a constructive deal but no deal. In particular, the Brexit negotiation process looks to have become even more complex. In this situation, progress might be slow and could even stagnate. Overall, the election outcome raises the risk of a ‘no-deal’ scenario. This could potentially be avoided, by extending the time period for negotiations, with a transitional arrangement.

Sterling weakens, with further downside in no-deal scenario

As a result of the election outcome, sterling weakened by 2% versus the US dollar and the euro. This is because the probability of a ‘no deal’ has risen and there will be political uncertainty for a prolonged period of time. The downside risks to sterling have risen because of this higher ‘no-deal’ risk. If financial markets were to price in a ‘no-deal outcome, GBP/USD could to fall to 1.20 and EUR/GBP could rise above 0.93. If the government appears to have  a clear, broadly-supported strategy, markets may somewhat price out the ‘no-deal’ risk. In this case, we would expect GBP/USD to to find support in the 1.25-1.26 area and EUR/GBP to top before 0.90. Overall, we remain of the view that sterling is cheap on the basis of long-term valuation metrics.