Conservative victory restores business confidence – for now

Boris Johnson’s election victory has provided his Conservative government with a parliamentary majority of 80 seats, sufficient to break the Brexit deadlock. The UK is now expected to exit the EU on the current deadline of 31 January 2020, on the terms of Johnson’s Withdrawal Agreement.

Many of the new seats came from constituencies that have traditionally returned Labour MPs but voted strongly for Brexit in the 2016 referendum. Accordingly, the government will find itself under pressure from its new northern constituencies to increase public spending, while continuing to cater to traditional conservative demands for low taxes. Johnson has already indicated he intends to square this circle through increased borrowing.

Conservative victory a relief for businesses

The election has brought immediate relief to investors and businesses. Firstly, it is now all but certain that the UK will formally exit the EU by 31 January. At this point a ‘transition phase’ - during which the UK’s status vis-à-vis the EU will not change - will begin, as well negotiations for a final trade agreement. 

The increased certainty regarding Brexit has restored a degree of confidence in the economy. This will likely lead to the freeing up of funds put on hold until greater clarity over Brexit emerged. Similarly, commodity industry representatives, such as the UK-based International Steel Trade Association, as well as the European Steel Association, have welcomed the new government. Immediately after the election, Sterling temporarily rallied to a three-and-a-half high against the Euro.  

Secondly, the Conservative victory has removed the prospect of a Corbyn government and its pledge to nationalise large companies in the telecommunications, utilities and energy sectors. The UK-focused FTSE 250 index surged by over 5% on the election result.

Outlook remains highly uncertain

Although it is clear that Brexit will happen, however, uncertainty over its timing and nature will remain significant over the next year. The transition period is a temporary measure, set to expire on 31 December 2020. If a trade deal is not agreed by then, the UK and EU will return to a ‘no deal’ outcome in which both trade on WTO terms.

Key Brexit dates

31 January 2020

UK departs the EU and transition phase begins

30 June 2020

Deadline to decide whether extension to transition phase is needed

31 December 2020

Transition phase ends

1 January 2021

Beginning of a new relationship – with or without a trade deal

 

Therefore, while Johnson’s Withdrawal Agreement is expected to pass through the new parliament, the risk of a no-deal Brexit remains. The UK and the EU must now negotiate a trade agreement before the end of 2020 and the UK must decide whether to request an extension by June 2020. To stress that such an extension is not an option, Johnson has introduced legislation to make it illegal for the UK to request one. This has driven an increase in investor jitters this week, especially in currency markets where sterling has now entirely unwound its post-election gains.

However, we believe that this move is largely symbolic, as Johnson’s significant majority will allow him to repeal the law quickly should an extension become necessary. The move had also been extensively telegraphed by the Conservatives ahead of the election, suggesting that the market response this week may be a late overreaction.

Even so, these negotiations are likely to present a significant challenge owing to the restricted timeframe. It is unlikely that the EU and the UK will reach a comprehensive free trade deal, including financial services, within 11 months.  By comparison, the EU’s less ambitious free trade agreement with Canada took seven years to negotiate.   

Instead, we expect that the UK will be able to negotiate only a limited trade agreement covering a small number of sectors, which would serve as the foundation for later additional agreements. Crucially for the UK, this deal is not expected to include the services industry.

An unclear budget

Many of the Conservative Party’s new voters are in economically disadvantaged, northern regions of England. To keep these voters on side, Johnson has promised to increase the government’s net public investment spending increase from the current 2% of the GDP to more than 3%, or by GBP65 billion per year. Spread over he next several years, this increase will cover some GBP 100 million to be spent on large infrastructure projects.

Key Conservative budget policies

  • GBP320 million reduction in business rates in 2020-2021, GBP10 million per year thereafter (0.03% tax cut)
  • GBP2-3 billion reduction in national insurance payments (0.07%-0.1% of GDP)
  • Public investment spending increase to GBP65 billion per year (3.1% of GDP)

 

However, it is unclear how these spending plans will square with the Conservatives’ pre-election pledge to simultaneously introduce tax cuts (see table above). The Office for Budget Responsibility, a UK government body tasked with providing independent analysis, forecasts that this increase in public spending will be funded by increased investment borrowing of up to GBP20 billion per year over the next five years. As it will not be used to fund day-to-day spending, this sum will not be included in the budget deficit but is an overall equivalent of 0.8% of GDP. 

Since the vote to exit the EU without a clear plan, the UK business environment has been hampered by uncertainty. In the months preceding the general election, uncertainty has also been driven by Labour pledges to nationalise sections of the economy, worries over a potential hung parliament, as well as the continued threat of a no-deal Brexit. For this reason, investors have welcomed the Conservative majority. Crucially, perhaps for the first time since the 2016 referendum, the government appears to have a clear plan on how to proceed with Brexit over the next few months. 

However, beyond this short-term horizon, the risks of a no-deal Brexit remain, and the government has set itself another challenge of delivering a free trade agreement in 11 months. An outlook covering the following five years of Johnson’s government offers even more uncertainty, as it is unclear how the UK will balance public investment increases with tax cuts.

Filip Rambousek

Politics Analyst, Europe and Central Asia