As polls in the UK tighten ahead of Thursday's election and the possibility of a hung parliament looms, JP Morgan is suggesting a stronger Labour showing could, contrary to the prevailing market view, help support sterling.
The rationale being that a centre-left coalition of Labour, the Scottish Nationalists and the Liberal Democrats would push Britain towards a softer Brexit, a better scenario for the UK economy in the bank's view.
JP Morgan strategists believe a Tory win, whatever the size, will see the country leave the single market and the customs’ union with negative consequences for UK trade.
“Brexit is still likely to feel rather hard insofar as it is liable to circumscribe the UK’s single market access, even if the change in the electoral timetable should temper the tail risk of an outright disorderly Brexit in 2019,” they said in a note last week.
The fact that one of the largest US investment banks has taken up a position at odds with the market is a testament to the level of unpredictability that currently stalks FX markets.
For Irish exporters, who have borne the brunt of the Brexit-related volatility in sterling, Thursday’s vote has the potential to provide some welcome relief or further erode their position.
Since the referendum last June, sterling’s value against the euro has ranged between 77p and 91p, damaging the competitiveness of Irish exports, denting UK tourist numbers, and eroding the profitability of companies that report in euro but generate revenue in the UK.
Currently at 87p, sterling remains roughly 2 per cent higher than when the election was called back in April, suggesting markets remain positioned for a big Conservative party win despite a tapering of support for Theresa May's government in recent days, says Mark O'Brien, head of the FX desk at Investec.
“The thinking is that if she has a clear majority it gives her a firm hand to go and negotiate for Brexit without worrying about the left and right flanks of her party, never mind the opposition.”
The Conservatives currently have a working majority of 17 seats if the five Sinn Féin abstentions are included.
Swing
O’Brien believes that increasing this to 50-plus would constitute a success for the party and prompt a 2 per cent swing in favour of sterling, moving it back to around 85p, “providing some welcome relief for Irish exporters”.
On the government's recent wobble in the polls, he cites two previous landslide election victories in the UK – Margaret Thatcher in 1983 and Tony Blair in 1997 – where support for the eventual winners appeared to soften in the final days before the vote.
He also believes modern polling techniques, particularly the use of online surveys which are weighted in favour of younger voters, may be underestimating the strength of the Tory vote.
Scenario two, according to O’Brien, is if the Tories win but with a slim majority, whereby May’s authority is undermined.“That would be a negative for sterling,” he says. The change is too difficult to predict without knowing just how weakened May might be by such a result.
He says scenario three is a hung parliament, which is likely to precipitate a sharp sell-off of sterling because of the uncertainty that would ensue. Nonetheless, there is a possible silver lining attached to this scenario.
“Perhaps a government will be formed that takes a softer tone to Brexit and that could lead to a strengthening in sterling in time,” he says, echoing the JP Morgan view.
The most unlikely scenario centres on a Labour victory, which O’Brien says would also prompt a major sell-off in sterling, at least initially, as the market takes a dim view of the party’s economic policies, particularly its plan for a rise in corporation tax.
“But again the possibility of a softer Brexit might see sterling strengthen in time, but the initial reaction would be a sterling sell-off,” O’Brien says.
Softer Brexit
“From an Irish perspective a Labour win and a softer approach to Brexit might be good, but in the short term for the Irish exporter a strong Conservative win would be better.”
There's another factor that underpins the current euro/sterling dynamic and that's the European Central Bank. Frankfurt holds its monthly meeting on the same day as the UK poll, and firmer indications about how fast it plans to conclude its quantitative easing (QE) programme is also likely to have a bearing on the euro/sterling exchange.
“You have essentially a double whammy for Irish exporters that are all coming to a head next Thursday,” O’Brien says. “The market is expecting the ECB to firm up its language around monetary policy and to allude to the tapering of its QE programme. If the language is stronger, you could have a strengthening of the euro against sterling.”
Combined with a surprise UK election result, this could heap further pain on exporters here.
However, O’Brien points to recent euro zone inflation figures which were weaker than expected, and a possible Italian election in autumn as grounds for the ECB to be less hawkish than the market wants.
Either way, Thursday promises to be busy day for analysts.
