Evercore Pan Asset

Markets are taking an optimistic view of the UK election. Some think the Conservatives will still win a small majority, as the political betting and their own preferences point them in that direction. Some think that whoever wins there will have to be a new policy to cut spending and to curb the deficit. In the event of a hung Parliament they look forward to negotiations, the formation of a coalition or minority government that can govern, and the outbreak of commonsense on the country’s financial problems.

At Evercore Pan we ask ourselves What if the polls are right? Since Mr Clegg’s success in the first TV debate between the three Leaders all the polls have pointed to a decisive upward movement in support for the Lib Dems, and falls in support for both Labour and the Conservatives. The consistent average of recent polls put Mr Cameron’s Conservatives on 32%, a fraction below the 32.3% they gained in 2005 when they won just 198 seats in a 646 seat Parliament, and puts Labour on 28%, compared to the 35.3% they won in 2005 which gave them 356 seats. The Lib Dems are recording around 30-31% compared to the 22.1% in 2005 which produced 62 seats for them.

The pundits say that on current poll ratings Parliament will have around 100 Lib Dem MPs, and Labour would hold more of the other seats than the Conservatives. Whilst both the Conservative and Labour parties say they do not think the polls will stay the same or be proved right in the end, they are both changing their campaigning strategies implying they also think there has been an important if temporary change of public opinion. The Conservatives had hopes to be winning a group of seats from the Lib Dems in the south. Now they have to worry about seats where a Conservative MP was elected in 2005 with a small share of the vote, and where the transfer of sufficient Labour votes to the Lib Dems could give the seat to the Lib Dems. On the positive side for the Conservatives, with Labour support lower than they were expecting at the start of the campaign, they can put more resources into seats needing larger swings to oust Labour MPs, given the unpopularity of Labour in the polls. The Lib Dems, who started the campaign by trying to keep hold of marginal seats in the south whilst pushing a bit on marginal Labour seats in the North, are trying to find more people and resource to put into more challenging conquests. On these poll findings they are spoilt for choice in what to attack, but probably have to concentrate on the more realistic ones. Labour is having to shore up its heartlands, with plenty of effort going in to defend seats once thought safe.

It is of course possible that opinion swings again sharply as it did after the first TV debate. Today’s polls also say that most people do not want a hung Parliament, so they may end up voting in more traditional ways to avoid that. From here, given the ability of the polls this election to swing so sharply, either of the main parties could win it. The bookies odds give the Conservatives more chances of benefitting from such a swing than Labour.

Were Parliament to be hung there is no guarantee that there can be an easy coalition between the Lib Dems and either of the other two main parties. In 1974 when we last had such a situation there was no agreement, and after a few months of minority government led by Labour there was a second General Election which did strengthen Labour’s position somewhat. Subsequently there was a period of coalition with the Lib Dems, which allowed that government to continue for most of the five year term. In 1976 the UK did need to borrow from the IMF, who imposed cuts on public spending to deal with the then budget deficit. That deficit was lower as a proportion of National Income than the current one.

A coalition government if formed would be unlikely to last for a full Parliament. The parties to such a deal would always have an eye to their own popularity relative to their partners come the next general Election. The junior partners might want to leave the coalition before the following Election, to give some time to distance themselves from the main party in the alliance. None of it is conducive to politicians wanting to make cuts in spending or to impose tax increases on more than a handful of very rich people and companies.

Our advice remains simple for investor. There is political as well as financial risk in the UK which urges caution concerning government bonds. In share markets we prefer the large company share index of groups that are mainly trading and making profits abroad. Current ratings offer investors some discount for the UK specific risks which do not apply so much to international companies based here.

Meanwhile the Greek tragedy continues, as a warning to heavily indebted countries everywhere. Greek bonds have continued to fall, giving interest rates in the range 9-13% on Euro instruments. These rates are far too high for the Greek state, and are designed to force further spending cuts and soft loans from the EU and IMF. On balance we expect the EU and IMF to find some way out to avoid a Greek default, but betting on that would be high risk. It is unlikely the Germans will want to move before their May elections to be any more helpful, and they are important players.