November 28, 2017 / 5:38 PM / a year ago

UK investors underestimate chance of Labour government, Scotiabank says

LONDON (Reuters) - Investors are underestimating the chances that Britain’s opposition Labour party will win power, given the instability of Prime Minister Theresa May’s administration, Scotiabank, a primary dealer of British government bonds, said on Tuesday.

A woman leaves a Scotiabank branch in Ottawa, Ontario, Canada, May 31, 2016. REUTERS/Chris Wattie -

The Canadian bank is the latest large financial institution to consider the prospects for British assets against the prospect of a Labour-led government, with opinions varying.

Scotiabank said that while the gilt market has priced in the economic disadvantages of Brexit, it was not adequately reflecting political risks.

Long-dated bond yields especially may rise if a Labour government under Jeremy Corbyn looked likely, on the assumption more bonds would be issued to fund higher public spending.

“Theresa May has an unstable government, is reliant on DUP support and has a badly divided cabinet,” Scotiabank European fixed income strategist Daniela Russell said in a note to clients, referring to the Democratic Unionist Party, the Northern Irish party propping up May’s government.

May lost her Conservative Party’s majority in parliament in an election in June and her key ministers are clashing on how to approach the negotiations with Brussels over Britain’s departure from the European Union.

Labour’s prospects could be bolstered by the damage done to household spending power from high inflation and weak wage growth, Russell said: “If the real income squeeze is going to persist – and economic growth is going to remain lacklustre – surely the appeal of the Corbyn alternative will remain strong?”

Britain’s budget forecasters slashed their outlook for economic growth last week and ramped up borrowing projections into the 2020s. The move was widely expected and the gilt market showed only a modest reaction.

But investors were not pricing in the risk of a no-deal Brexit outcome or the chance of another election, Russell said, adding that she had little hope the uncertainty about the outcome of Brexit talks would be lifted soon.

Opinion polls have suggested the Conservatives and Labour are running neck and neck in terms of voter support.

As a primary dealer, Scotiabank buys gilts directly from the British government to sell them on, helping to create a liquid market.

On Monday, Morgan Stanley said it assigned at least a one-in-three chance that there would be an election before the next scheduled date in 2022 that would yield a Corbyn-led government.

If markets felt that the chance of a hard Brexit or a Labour government were on the rise, there could a “sharp reaction” among investors - a risk given Britain’s reliance on them to fund its large current account, Morgan Stanley, which also acts as a primary dealer for gilts, told clients.

Other investment banks are more sanguine about the possibility of a Labour government.

Last month, Credit Suisse said a Labour government could seek a Brexit deal that left Britain closer to the EU than the ruling Conservatives, something which would be better for the economy.

Labour has said it wants to give a major boost to investment that has long lagged behind international peers, as sought by business groups.

Bank of England Governor Mark Carney on Tuesday said the approach of Brexit was reducing the appeal to investors for shares in UK-focused companies but not in bigger, more global companies or for British government debt.

Reporting by Andy Bruce, editing by Larry King

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