The Implications of the UK Election

UK Election

The United Kingdom has its general election on May 7th, and the election outcome could be intriguing for a number of reasons. Typically British elections are dominated by the Conservative and Labour parties, with the Liberal Democrats far behind in third place and all the other parties barely winning any seats in parliament. This time the Scottish National Party (SNP) is expected to overtake the Liberal Democrats as the third-largest party in parliament, and a slew of smaller parties such as the UK Independence Party could upend the vote. Beyond the political storylines, however, the election outcome could have implications for your portfolio.

Last September, Scottish voters narrowly rejected a referendum on whether Scotland should break away from the United Kingdom and become an independent country. A “yes” vote on independence likely would have hurt many British companies by creating uncertainty about what currency Scotland would use and how a newly independent Scottish economy would be managed and regulated. But the rejection of the referendum didn’t put the independence issue to rest. Support for the SNP, which strongly backs Scottish independence, has surged over the past 7 months. Success by the SNP in the upcoming election would increase the chances of another independence referendum.

A promise that Prime Minister David Cameron made could have an even more widespread effect on investors’ portfolios. In 2013 he vowed to give British voters a referendum on whether the UK should remain part of the European Union. Such a referendum won’t necessarily occur: the Conservative party would have to win the upcoming election and be able to form a government with only coalition partners who also agree to the referendum. But if it does occur, the political and economic uncertainty created by such a referendum could adversely affect not only British companies, but also companies around the world that operate in the UK or trade with the UK.

Many of these effects from the election may not occur for a while. Cameron’s proposed referendum, for example, wouldn’t take place until 2017, and much could change in British politics before then. But the general effect of the election for investors could be to increase the impact of political risk on financial markets. So far this year, despite conflicts in the Middle East and drama surrounding the Greek government’s finances, markets have largely shrugged off political risks. The UK election has the potential to change that.

The Effects of Scotland’s Vote

Scotland Flag

On September 18th residents of Scotland will vote on whether to break away from the United Kingdom and become an independent country. Even if the Scots vote for independence (polls suggest the vote will be close), Scotland wouldn’t actually become its own country until early 2016. But for investors a “yes” vote on independence could have negative effects long before that for British stocks, particularly those of Scottish companies in industries such as banking.

In the event of a “yes” vote, it’s still not clear what currency Scotland would use (like the rest of the United Kingdom it currently uses the British pound). The leading advocates for independence argue that Scotland could simply continue to use the pound as part of a currency union with the rest of the U.K. But there are a few problems with this idea. Even if the rest of the U.K. agreed to the currency union, it would face the same problem that the euro zone has faced in recent years, where a currency shared by governments with different fiscal and regulatory policies led to economic calamity.

Furthermore the U.K. government has pledged not to join a currency union with an independent Scotland. Therefore if Scotland kept using the pound, its monetary policy would be managed by the Bank of England, which in theory wouldn’t be considering the state of the Scottish economy when making its decisions. These problems—and the general uncertainty surrounding the potential Scottish currency decision—could harm the Scottish economy and lead to additional costs for British companies.

There is further uncertainty for companies in highly regulated industries such as banking. Many Scottish banks think that their clients would prefer to have their bank regulated and backstopped by the government of the United Kingdom rather than the government of an independent Scotland (its banks are probably too large for Scotland to credibly backstop anyway). Many Scottish financial companies—including Royal Bank of Scotland and Lloyds Banking Group—have therefore declared that they will move to England in the event of a “yes” vote.

These uncertainties lead to higher costs (and therefore lower profits) for companies as they have to prepare for the various possible outcomes. If the independence referendum succeeds, these uncertainties and the associated costs will only increase further.