1st June, 2017
DB News, IC Insights
Uncertainty to follow, whatever the outcome…
As we sit 6 days away from the UK General election, one could be forgiven for thinking back to last June’s Brexit vote. At 10pm on the evening of polling day, the leave campaign was still priced in at 10-1 with certain well known bookmakers. Just as they were then, investment markets today are pricing in a win for Theresa May, including a larger majority than the one she currently holds. The odds for her outright victory remain more convincing than the remain campaign held last year, though her odds for such winning with a significant majority are getting tighter.
Of course, we are not in the business of making bets. Even if we had called last year’s Brexit vote and the US election results correctly (we didn’t), we would have still been surprised by the investment market reaction that followed.
So, at times like these, it is important for our Investment Committee to understand the implications for our portfolios under multiple scenarios. In doing so we hope to work out the effect of each potential outcome, ensuring the portfolio range is as robust as can be, whilst also offering enough flexibility to take advantage of any opportunities that might emerge.
Taking the most probable scenario in isolation; if the Conservatives win a large majority it should make it easier for them to agree to a transitional arrangement; prolonging single market access for two or three more years after March 2019 (it is this assumption that has led to a strengthening pound since the election was announced). The initial market reaction would likely be quiet, with markets on the whole still expecting this outcome. We must therefore consider what it would mean for markets if the election produces a surprise outcome that doesn’t involve a larger Conservative majority.
The first alternative, is that the Conservatives win the election, but fail to meaningfully increase their majority. This would weaken May’s hand in negotiations, increase the chances of a “no deal” outcome and most likely reverse some of the recent increases in the pound. As seen back in June after the largely unexpected Brexit vote and subsequent pound weakness, the FTSE 100 looks set to benefit (most of its constituents earn their money abroad) but smaller equities could suffer.
Now to the elephant in the room…
What if May falls in June, and Corbyn becomes PM?
Markets would have to digest the effect of higher corporate tax, higher government spending and the nationalization of various companies. Those effected by the latter would likely fall significantly in value due to uncertainty, and higher corporate tax would be a clear negative for all equities’ net profits. Clearly, those companies who pay the highest percentage of their tax in the UK are most exposed to this risk… suffice to say the likes of Starbucks would probably be ok!
Government bond yields would likely rise, given that Labour would need to drastically increase government borrowing. I suspect markets might be concerned by Labour’s ‘Fiscal Credibility Rule’, focusing only on current expenditures. They would also be sceptical of the party’s ability to raise as much tax as hoped from its proposed measures. Interestingly for each 1% reduction (yes, reduction) in corporation tax, evidence shows this raises an extra £5.6 billion per year in tax revenue.
Our Brexit position would remain equally unclear. Labour’s manifesto states that it will “have a strong emphasis on retaining the benefits of the Single Market” (soft Brexit), while also claiming that “freedom of movement will end when we leave the European Union” (hard Brexit). It is the incompatibility between these two statements that is at the very heart of the Brexit debate. In response, the pound would probably be torn between a slightly higher probability of a soft Brexit (strength) and higher borrowing costs in combination with a dubious relationship with businesses (weakness). Under this uncertain outlook for sterling, the pound would probably fall.
So, as you can see it’s all very interesting! What happens to the pound is likely to continue to be key for UK equities in particular. If the pound stays flat, equities would be expected to fall, with domestic companies underperforming those internationally exposed. A fall in the pound could support internationally exposed companies, as we saw after the Brexit referendum. Alternatively, if sterling rallies sharply on hopes for a soft Brexit, large-cap equities with international exposure could come under pressure. We think the latter is the least likely outcome.
Overall, even a large majority win by the Conservative Party would not dramatically reduce the uncertainty over the type of deal the UK will eventually get, and the market reaction on the day would likely be limited. Irrespective of the election result we see increased short term risk to UK equities, and have reduced positions selectively over the course of this year. Our equity exposure is preferred oversees (excluding the US). Obviously we can’t predict the election result or the market outcome, but we can play the probabilities, reduce your risk and seek out opportunity.