The snap UK general election is almost upon us, with the political outlook far less certain than when the election was called on 18 April. We assess the various scenarios, and conclude a neutral tactical weighting in UK equities continues to be valid on a balance of probabilities. The global nature of many large UK companies should mitigate some of the domestic political risk, and global portfolio diversification is key.
Many people have been asking us about our views on the upcoming UK general election, particularly given the significant shifts in polling as we approach the final leg of campaigning. The view this time is further complicated given the implications for the Brexit negotiations in addition to the more traditional policy debates. As always, we take no political stance as a firm, however we recognise that political events do have an effect on market expectations. It is in this context that we will discuss market impacts.
From an investment perspective, short-term political implications have been especially difficult to predict, and our experience of recent years has shown how counterintuitive market reactions can be (for example, the Brexit result and Trump elections in isolation were generally expected to trigger risk-off moves rather than the equity rallies that appeared).
We can however make some broad observations as we head into the election, drawing what we believe are rational conclusions in order to inform our tactical positioning and asset allocation.
While the credibility of pollsters and (to a lesser extent) bookmakers has been dented recently, they remain the best data we can get as to voter intentions. Starting with the polls, the chart below shows just how much the Conservative lead appears to have eroded in the last few weeks.
Some polls to date have had the Conservative lead as low as three points with 42% for the Conservatives versus 39% for Labour – well within the margin of error, generally considered to be about +/- 3%. However, it is worth noting that there is dispersion between results from different pollsters, with other recent polls showing a comfortable 12-point lead. It is therefore important to take these data in context and in aggregate, rather than focus too much on outlier data.
Looking to the bookmakers for a different perspective, the odds still heavily favour the Conservatives, even if they have lengthened slightly in the last couple of weeks. The implied probability of the Conservatives winning the most seats (see chart below, this includes a hung parliament where the Conservatives have the most seats) is still above 90%, while the probability of a Conservative majority is in the range of 75-85% (source: Oddschecker, as at 1/6/17).
As well as considering which party, if any, will have an overall majority, there is also the question of the size of the majority – after all, the Conservatives already had a 17-seat majority when they called the election. Until recently it had been assumed that the Conservatives would secure a very strong majority but that seems significantly less likely on the recent data. The chart below shows the implied Conservative majority based on the latest polling data.
On 29 May, an ICM survey showed a 12-point lead for the Conservatives (45% versus 33%), which translates to an approximate projection of a 76-seat majority. Two days later, the YouGov poll showing the three-point lead referenced above (42% versus 39%) translates to a four-seat shortfall projection (and therefore a hung parliament). A tight race makes for volatile numbers, and markets are averse to uncertainty, contributing to some pressure we’ve seen on sterling in the last couple of weeks. This also highlights the difficulty of translating broad polling data into actual seats in a first-past-the-post system.
Taken together, we consider the likelihood of various election outcomes and then consider possible implications for the monetary and fiscal policy outlooks, the perceived impact on the business environment and the response of UK asset classes relatively to the global backdrop. This task is not a simple one, with many different elements pulling in different directions and to different magnitudes. Frankly, there is no playbook for these electoral outcomes, and it is possible to create alternative and opposite responses that are all at least feasible (if not probable).
Our approach has been to take each election outcome, and consider the impact on assumptions for monetary and fiscal policy as well as the business environment and determine an aggregate outcome for asset classes that we believe is the strongest case on the balance of probabilities. Here is a summary of these six scenarios:
Shy Tories come out in force or there is a late swing in the polls; PM gets her wish. There is a modest relief rally in risk assets. The Bank of England looks to play catch-up in a business-friendly environment with greater legislative certainty.
Much improved position for the Conservatives, reducing uncertainty in the legislative outlook with a more solid negotiating position being perceived. No real surprise, but a modest relief rally.
There was no real point in having an election with little meaningful change, aside from a longer Government term during the Brexit process. Pressure in sterling and gilts eases as less market-friendly scenarios are avoided, although some risk of a leadership challenge. Equities largely unchanged with this effectively the base case.
The PM’s calculus is proved wrong, and this is an unequivocally ‘bad’ outcome for the Conservatives. Core policies remain intact, but perception of a weaker negotiating position and strong possibility of a leadership contest add to uncertainty.
There is huge uncertainty while domestic party negotiations go on, driving short-term risk-off moves. Most probable result is a ‘progressive alliance’ of Labour, the Liberal Democrats and Scottish National Party. Fiscal austerity and recent business-friendly policies are unwound.
Anti-establishment sentiment causes an election shock. Business-friendly policies are unwound, and debt-fuelled infrastructure spending begins. Bank of England looks to offset higher public borrowing with less accommodative monetary policy. Counterintuitively, sterling appreciates on the likelihood of a softer Brexit.
A reasonable Conservative majority (still the most probable outcome) is likely to be seen as more-of-the-same from a party that is generally seen as business (and therefore equity market) friendly. This is likely to result in a limited relief rally, benefiting equities and sterling while easing pressure on the perceived safe-haven of gilts. An especially strong showing (>100-seat majority) may also give the Conservatives scope to introduce further business-friendly policies and address some structural fiscal issues. Things become more complicated if it transpires that the Prime Minister misjudged calling the election. A smaller majority weakens the perceived negotiating position of the Government, and it could give rise to a fresh leadership challenge. While this is unlikely to give rise to policy changes, it is nevertheless not a particularly market-friendly outcome.
Although unlikely, a hung Parliament – with no party securing an overall majority – or a Labour majority would be the least market-friendly outcome and could lead to a significant negative impact on equity markets. Both outcomes would likely give rise to a Labour-led government, either outright with a Labour majority, or through the ‘progressive alliance’ of Labour, Liberal Democrats and the Scottish National Party. Under both scenarios, we would expect policies that are generally considered bad for business (such as higher corporate tax rates) and further fiscal spending, supported through borrowing.
It is perhaps at this juncture that Brexit effects become most significant and shift the calculus compared to the traditional response, with a Labour-led Government seen as much more likely to give rise to a ‘soft’ Brexit, which prioritises access to the single market. For a Labour majority, it is possible that we see sterling rally as markets rapidly price-in the soft Brexit assumption, though gilts are likely to suffer on the prospect of significantly higher government borrowing levels, as we saw in the US following Donald Trump’s election. The reverse would likely be true for a hung Parliament with the period of extreme uncertainty initially overwhelming other considerations, driving sterling and gilt yields even lower until there is greater clarity.
You will notice that under most scenarios, we don’t see any change in monetary policy. The Bank of England (BoE) has been playing something of a waiting game, and is not currently under much pressure to raise rates – we think the BoE will let the dust settle in the months following the election before signalling any potential policy changes. However, more rapid action could be needed under two of the scenarios. A Conservative landside would remove much uncertainty on the legislative outlook and foster even more business-friendly policies, which could well prompt the BoE to play catch-up. Conversely, under a Labour majority, we foresee a scenario where the BoE attempts to offset the effects of fiscal stimulus (fuelled by higher borrowing) with tighter monetary policy sooner than would otherwise be the case.
From an investment point of view, while the election result is likely to have some impact on domestic assets, we advocate portfolios that are diversified geographically as well as by asset class. The key drivers of long-term returns are therefore the much larger global macroeconomic factors that we discuss in our regular publications.
On a tactical basis, we have considered the UK assets within our broad asset allocation, and believe no change to our current stance – neutral on UK equity – is warranted, with the risks finely balanced. While we do see the magnitude of the downside risk for ‘equity negative’ scenarios as greater than the upside potential for the ‘equity positive’ scenarios, we also see the equity negative scenarios as much less likely overall. Therefore, on probability-weighted balance, we see a neutral UK equity weighting as appropriate.
We are further assuaged in our decision given the international flavour of the UK equity market, with the majority of revenue of the large stock-market constituents coming from overseas. While not immune to domestic issues, particularly should corporate tax rates change, this global activity does mitigate some of the domestic political and economic risk.
We will continue to monitor the election developments, as well as other global factors that are getting less news coverage but are also important for the ongoing management of our clients’ investments. We will provide a further update once we know the election result.