The looming UK election is one big gamble for investors

Brits are being asked to vote in an election that could end years of paralysis caused by Brexit. For investors, there are new risks—whatever the result.

Traders face weeks of tumult ahead of December 12, when the United Kingdom holds its third general election in four years. The vote could end over three years of Brexit uncertainty, or plunge the country’s political system deeper into chaos.

Each potential outcome comes with risks for investors. One scenario is another divided parliament and no path forward on Brexit. Or Prime Minister Boris Johnson could wind up emboldened, resurfacing fears of a damaging break with the European Union. The vote could also install a left-wing government led by Labour chief Jeremy Corbyn, which investors worry would mean major structural changes to the UK economy.

“Take nothing for granted in the forthcoming election,” Brian Hilliard, chief UK economist at Société Générale, warned clients in a note Tuesday. “Just ask Theresa May,” he added, referring to the former prime minister who gambled and lost her majority in a risky snap election in 2017.

Advantage Johnson

Johnson’s Conservatives have a solid advantage over Corbyn’s Labour Party in early opinion polls. But the British public is sharply divided over Brexit, causing many voters and even some politicians to switch their allegiance to other parties. The pound is effectively trading flat as traders wait for campaigning to kick into high gear.

Investors aren’t as shaken by the prospect of a Johnson victory as they were a few weeks ago. That’s because the prime minister secured a Brexit deal with the European Union before he called the election, and will ostensibly campaign on getting his agreement through UK parliament. That the European Union agreed to again extend the Brexit deadline to January 31 provides added comfort.

After months of stalemate, Britain is on course for an early general election after the House of Commons approved a December 12 poll.

“It looks less likely that Boris Johnson has to campaign on a hard Brexit,” said Kallum Pickering, senior economist at Berenberg Bank. He expects Johnson to narrowly win a majority and subsequently get approval for his deal.

Pickering views this as the most favorable outcome for investors, since a Conservative majority would clear the way for market-boosting deregulation and fiscal stimulus in the form of infrastructure spending and possible tax cuts.

But a Johnson win — which would likely be followed by a swift Brexit in January — also poses risks. For one, the exit deal he secured with the European Union would ultimately erect significant trade barriers for many companies operating in the United Kingdom, hurting businesses that would otherwise be propped up by his policies.

Plus, Britain may not be able to work out the huge number of complex trade issues that would need to be resolved by the end of 2020, when a transition period included in Johnson’s deal would expire. That raises the possibility that Britain could wind up trading with its biggest export market on highly unfavorable terms.

On the other hand…

For investors, who already face a UK economy on the brink of recession, the alternatives aren’t demonstrably better.

The Labour Party, should it wind up in power, may choose to launch a second referendum that could reverse Brexit entirely. That would send the pound and other UK assets soaring. (The pound is currently trading below $1.29. Before the first referendum in 2016, it was close to $1.50.)

But Corbyn’s Labour Party terrifies some in the business community. The party’s manifesto from 2017, its most recent, says it would “overhaul” regulation of the financial system and nationalize certain “key” utilities.Corbyn has pledged to force large companies to give at least a third of the seats on their boards to workers, and to strengthen unions’ bargaining rights.

Nissan cars are pictured, parked in a lot at its' Sunderland plant in north east England on March 16, 2019. - Carmakers are facing fallout from Britain's decision to leave the European Union, a Chinese economic slowdown and from Beijing's ongoing trade row with the United States. (Photo by ANDY BUCHANAN / AFP) (Photo credit should read ANDY BUCHANAN/AFP/Getty Images)

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“The economy and financial markets may either have to cope with a combination of a hardish Brexit and business friendly policies under the Conservatives or a softish Brexit and business unfriendly policies under Labour,” Paul Dales, chief UK economist at Capital Economics, wrote Tuesday in a research note. “That limits the upsides for equities and the pound whatever the election result.”

Dales thinks that if Labour wins a majority, Brexit would be delayed beyond January 31, after which there’s a 50% chance that the party strikes of a deal that would maintain closer ties to the European Union, and a 50% chance of a second referendum.

The calculus changes if Labour doesn’t score a majority, and is forced to cooperate with either the Liberal Democrats or the Scottish National Party. That could mitigate the scope of some of Corbyn’s reforms.

There’s also the threat of another parliament in which no party claims a majority. That would further muddle the picture for Brexit, and mean additional years of uncertainty.

“We cannot exclude the possibility that a general election in December returns another hung parliament in which the Conservative Party leads with a handful of seats short of a working majority,” Goldman Sachs economist Adrian Paul wrote in a note to clients Wednesday. The result? More of the dynamics that led to the “current impasse.”