Will Sterling Markets See a Silver Lining If Boris Leaves?

(Bloomberg Opinion) -- Boris Johnson could withstand the latest concerted attempt to remove him from office — he is not known as the greased piglet for nothing — but it is wise to consider what may happen if his tenure does end up being even shorter than that of his ill-fated predecessor Theresa May.

Markets as a rule hate uncertainty, but a premature defenestration of Johnson as prime minister, though a shock, would not qualify as a major surprise. Sterling may take an initial dip, as might U.K. equities, but likely only fleetingly. It would be akin to an embattled chief executive officer leaving a company. There could well be a premium for new management.

The recent “partygate” scandal has had minimal impact on sterling markets. There are other global events that are more pressing and influential. The sudden Federal Reserve hawkishness initially unsettled equities and has driven bond yields higher around the world. The U.K. Government bond market — known as gilts — would be the obvious domestic haven on both sterling and equity weakness. If there is persistent instability then there is the more assured safety of the dollar; and U.S. Treasury bonds would be preferable for unnerved foreign money.

A change of prime minister will rattle domestic markets, at least until the smoke clears and a new leader is in place. Nonetheless, the ruling Tory party’s reputation as the most successful political force in modern European history has not been earned lightly. Johnson won a commanding 80-seat House of Commons majority in late 2019 for a five-year term. The Tories can shapeshift on a dime. An alternative Labour government, or more feasibly a coalition of opposition parties, is not on the cards for a considerable time.

The two most likely replacements, Chancellor of the Exchequer Rishi Sunak and Foreign Secretary Liz Truss, are both from the right-wing of the party and are committed Brexiteers (even if Truss was a late convert). They differ in style but are naturally more fiscally conservative and Thatcherite than the more free-spending Johnson. It ought to be positive longer-term for gilt yields if government spending is more restrained.

There could be a small premium to steadying the ship after the six years of political volatility. The recent strength of the pound versus the dollar is principally a correction to unremitting dollar strength. Sterling has also been strong versus the euro, but again this is mostly because the European Central Bank is the least likely to raise interest rates.

The Bank of England put a floor under the pound with its 15 basis point interest rate hike to 0.25% in December. Its next monetary policy review on Feb. 3 could see the first of three rate hikes this year to 1%. But a delay would reduce sterling's allure as it would imply a slower pace than the Fed's implied trajectory. The Brexit discount is still a factor in sterling's valuation and to the attractiveness of U.K.-listed companies.

The large cap FTSE 100 index has long been an underachiever due to a heavier weighting of “old economy” stocks compared with more tech-dominated U.S. indexes. However, it's been on a relative tear of late, with a 2.4% gain year to date — better than European or U.S. indexes and back to its pre-pandemic heights. Large caps have been outperforming, with the more domestically focused FTSE 250 mid-cap index little changed from mid-summer levels.

A dip in sterling would naturally attract more foreign buyers, particularly if relations with the European Union or political stability improve. That would filter down rapidly to the wider small- and mid-cap market which outperformed in the earlier part of 2021 when the Brexit deal finally happened.

Aside from politics, gilts have a tricky course to navigate: There are only 17 billion pounds ($24 billion) of supply scheduled for this quarter, but 10-year yields have actually risen more than U.S. Treasury yields in the past month. The supply drought is expected to end dramatically with one of the largest year-on-year changes to net issuance in recent history upcoming. Overall gilt issuance is likely to be broadly unchanged from this year's 200-billion pound pace. However, there is a major buyer missing; the BOE’s QE bond-buying program ended last year. It purchased all net new supply in recent years. 

From now on, the gilt market has to stand on its own, withstanding buffeting from interest rate rises and lower monetary and fiscal largesse. The huge pandemic fiscal stimulus is expected to go into reverse with planned net tax rises and energy price caps almost certainly revised sharply higher. A cost of living squeeze is coming down the track.

It’s all set to be a challenging year, whoever is the leader of the Conservative party and, thus, prime minister. That probably explains why there is some hesitancy in replacing Johnson. Local elections are due in May and are expected to be tough for the party — so any decision to boot Boris may have to wait till then. Ultimately, the deciding factor will be which leader has the best chance of securing the next Tory victory. Greased piglets do not have nine lives; but this one is certainly proving hard to hold down.

More From This Writer and Others at Bloomberg Opinion:

• Don’t Panic, Europe. That’s Not Inflation. It’s Just Gas: Marcus Ashworth

• Boris Johnson Has Kicked Off a Tory Battle of Succession: Therese Raphael

• What If Boris Johnson Is No Longer a Winner?: Martin Ivens

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

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