Ready-reckoning the markets post-UK election

April 29, 2015

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Next week’s British general election is unlikely to produce a clear winner. UK assets are likely to fall in the short term if negotiations to form a government drag on. They will slide further if an unstable minority government is formed. Persistent political uncertainty would risk depressing confidence, business investment and economic activity. This, in turn, could lead the Bank of England to keep interest rates lower for longer. Sterling – which, at $1.5280, has already lost 11 percent since last July – would decline some more. Historically expensive gilts and fully valued stocks may also underperform.

But a workable government will eventually be formed, even if it takes a second vote, and will be led either by the Conservative incumbents or Labour, the main opposition challenger. Different medium-term trends will emerge after the inevitable short-run volatility in sterling, gilts and UK equities.

LABOUR-LED GOVERNMENT

Sterling: The left-leaning Labour Party would reduce the budget deficit more slowly than the Conservatives. Looser fiscal policy would support economic activity, as would plans to raise the minimum wage. Together they could also generate a bit more inflation. Investors would then expect earlier and more rapid monetary tightening than currently anticipated. This would buoy sterling, especially against the euro, as long as foreign investors did not flee UK bond and stock markets.

Gilts: Slower deficit reduction and upward shifts in monetary policy expectations would cause UK bonds to underperform U.S. and German debt. But the absolute extent to which UK yields rise will probably hinge on bigger global forces. Investors’ reactions to the changes in U.S. policy rates and ultra-low, and even negative, euro zone bond yields may be more influential.

Equities: Roughly three-quarters of the earnings of FTSE 100 companies are derived outside Britain. So sterling strength would be a negative. A pickup in domestic economic activity might buoy smaller UK-focussed companies, such as Whitbread. Some stocks are vulnerable. Centrica, the utility, could be hit because Labour has pledged to freeze energy prices until 2017. Banks such as Barclays and HSBC will feel the brunt of concern about higher levies. Retailers and leisure companies, meanwhile, might see costs rise as a result of Labour’s plan to ban employer-friendly zero-hour contracts. Plans for a levy on tobacco firms would undermine their shares.

CONSERVATIVE-LED

Sterling: The Conservatives would be expected to reduce the deficit more quickly than Labour. The impact of this and other pledges may, however, be overshadowed by their promise to renegotiate Britain’s ties with Brussels and hold a referendum before the end of 2017 on the country’s membership of the European Union. Any short-term bounce in sterling immediately after the election could quickly reverse in the face of doubts about the UK’s membership of the European Union. Options markets would begin to price in higher sterling volatility. EU uncertainty could curb business investment and crimp growth. The Bank of England might raise rates later and more slowly than previously anticipated. That would undermine the pound, especially against the dollar.

Gilts: Slower-paced rate rises, and greater fiscal discipline, should in theory support the price of UK government bonds. But an exit from the EU could result in a permanent loss of GDP. Think-tank Open Europe said on March 23 that British GDP in 2030 would be reduced by 2.2 percent. Two leading German institutes on April 27 predicted an even bigger hit to GDP. Slower economic activity would depress tax takes and boost social welfare outlays, which could impede deficit reduction. An EU referendum could also spur the Scottish National Party to push for a second referendum on Scotland’s membership of the United Kingdom. All this would lift gilt yields.

Stocks: UK stocks have typically performed better under Conservative-led governments than Labour-led ones during the past seven decades, Citi strategists calculate. Since 1945, annualised total returns under Conservative-led governments have been 14.6 percent and 11.5 percent under Labour-led administrations, excluding the sharp fall in share prices under a Labour government in 1974, they say. But an EU referendum could make this a less stock market-friendly Conservative tenure. Companies in the financial sector and those with the biggest revenues from the EU are likely to be the most significant underperformers.

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