Once again the British electorate has delivered an unexpected political outcome. Having called the election to secure a larger majority, the Conservative party has lost the slender one it had and looks set to form a minority government. Most pressing for investors is whether this government can last, who will be prime minister and what will be the impact on the Brexit negotiations.

Given the range of potential outcomes, the best place to start is to identify the key messages the electorate delivered to their politicians. The first is that people are becoming tired of relentless austerity. Labour’s message of higher government spending and a better distribution of income caught the public mood. The second is a rejection of leaving the Brexit negotiations to a small, somewhat secretive group who would decide the UK’s future relationship with Europe.

This suggests that for the electorate to be satisfied with their elected politicians, we should see easier fiscal policy and a lower risk of a disruptive or “hard” Brexit. That is arguably the easy part. Understanding how the political establishment can deliver such an outcome is far more complicated.

The main problem relates to governing with a minority, and the challenges of being held to ransom by small single policy focus groups. There is a constant risk that the government fails and we face another general election.

Then there is the question of who will lead the UK through the Brexit negotiations. At this stage there is a high chance that Theresa May faces a leadership challenge, but even if that proceeds smoothly it risks further running down the clock on the two-year window for negotiations, currently scheduled to finish by March 2019.

Then there is the issue of the prime minister’s credibility as the negotiations progress – will the EU believe that the prime minister speaks with the authority of Parliament? It is possible but far from guaranteed. In short there are a large number of potholes on the road ahead.

How should we approach this as investors?

Faced with this uncertainty, the immediate market response seems fairly reasonable: a modest sell-off in the pound, a steepening of the UK yield curve and slightly lower bond yields. Looking ahead, assuming a base case of easier fiscal policy and a “softer” Brexit, we would expect higher yields, a steeper yield curve and stability returning to the pound.

However, given the many risks to this view, we suggest investors remain cautious. It may well be the case that British politics proceeds smoothly, but as we know, it has a habit of throwing up unexpected outcomes.

Mike Amey is PIMCO’s head of sterling portfolio management and a regular contributor to the PIMCO Blog.

PIMCO Blog

Source: http://capitalisthq.com/what-the-uk-election-means-for-markets/

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