It’s been a mixed year for UK assets with the British pound plunging on the one hand, while the FTSE 100 has been among the top performing global indices. Will the next Prime Minister influence this dynamic?
The issue currently dominating the UK investment landscape is that of the Conservative Party leadership contest between Liz Truss and Rishi Sunak, which will ultimately decide who shall be the new UK PM. The contest will be decided Monday, September 5th.
Despite initial losses in reaction to news of war breaking out between Russia and Ukraine, the FTSE rallied more than 13% off 2022 lows. It hasn’t been a straightforward year for the FTSE and there's been plenty of volatility with the UK benchmark index now trading back below the yearly open, as of writing.
The leadership contest appears to be taking a toll.
So, let’s unpack this issue and look at how the contest is impacting the FTSE as well as mapping out some possible scenarios in response to the potential outcomes.
How Will UK Leadership Change Impact The FTSE?
- Uncertainty driving markets
- Expectations and surprises
- Sunak impact
- Truss impact
- Base case scenario + FTSE chart
Uncertainty Driving Markets
The first thing to note here is uncertainty. If there is one thing that investors like least, it’s uncertainty. A change in leadership represents a major unknown for financial markets. With a change in leadership (often) comes a change in economic and fiscal policies, and a change in the regulatory environment which can have a sizeable impact on businesses and consumers alike.
Consequently, one dynamic for how the FTSE behaves around UK political shifts is weakness ahead of the change and a return to strength once the change is confirmed. This dynamic is referred to as a “relief rally”. We saw these conditions earlier in the year where markets weakened during the uncertain months during which Johnson faced calls to resign and votes of no confidence, before rallying once he confirmed he was leaving.
Expectations And Surprises
The next issue relates to expectations and surprises. Markets react far more strongly to surprises than they do to outcomes which were well signalled. In this instance, given that Liz Truss has been leading in the polls and is widely expected to win the leadership context, the FTSE is likely to react less if this win is confirmed than if Sunak pulls off a surprise victory.
With this in mind, the current sell-off in the FTSE can be partly attributed to traders’ expectations of how Truss’ proposed policies would likely impact the UK economy, bringing us onto the candidates themselves.
With Sunak’s former role as Chancellor of the Exchequer, he is seen as the better candidate for markets given his business savvy and financial knowledge. Sunak has emphasised his desire to balance the need to address the cost-of-living crisis with battling soaring inflation and has pushed back against the idea of increased borrowing and increased public spending. Critics have argued that Sunak’s proposals have been too business-centric and lacked the humanitarian element needed given the conditions facing UK households.
Truss, the Minister of State for Foreign, Commonwealth and Development Affairs, has taken a very different line from Sunak. Truss has proposed sweeping fiscal stimulus including direct support for households, as well as tax cuts, to help buffer the economy during the cost-of-living crisis and energy crisis currently gripping the UK. While there are certainly some near-term growth benefits to be gained from Truss’ plans, critics (including Sunak) argue that increased expenditure here will simply feed into higher inflation, requiring the BOE to tighten more aggressively, dragging growth down on a longer-term basis.
Base Case Scenario
If Truss is confirmed as the winner, ultimately the market reaction will likely be quite muted, given the expectation of such an outcome. There is good scope for the FTSE to still rally a little on the back of the confirmation, putting an end to the uncertainty of the contest.
The key point is that following the confirmation, traders’ focus will very quickly return to the broader backdrop and the fundamentals affecting the UK currently. Given elevated inflation and the expectations for further BOE tightening into next year, the FTSE looks likely to stay pressured unless we see a firm reversal in inflation and a shift in BOE expectations.
If Truss wins and her spending plans are seen to be pushing inflation up then there could well be much more downside for the FTSE in the coming months.
FTSE Weekly Chart
The latest rejection at key long-term resistance around 7579 has seen the FTSE reversing heavily lower. The market is now testing below the 7235 support level and below the rising trend line from the November lows. While the market holds below this region, look for a continuation lower towards the 6978 level next with a break there opening the way for a test of 6803 below.