After Theresa May called a snap General Election with the aim of increasing her majority in the House of Commons, the UK woke up to a hung Parliament on Friday. With Labour having ruled out a formal coalition with other parties and the Tories close enough to a majority to feel that they can manage as a minority government, probably supported by the Democratic Unionist Party (DUP), a minority government seems inevitable. Historically, such governments have fairly short lifespans so the possibility of another election in the short term is very real. Therefore, whilst it is hard to be certain about what has produced this result so soon after the event, it is worth considering what we think we know at this point.
There is significant anecdotal evidence that younger voters engaged in a way not seen previously in such elections, with the Labour Party being the primary beneficiary. Labour’s gain of Canterbury, a university town, on a 10% swing from the Tories would appear to back that up. There is evidence, as well, that the Tories lost votes amongst people who voted Remain in the EU Referendum. Theresa May’s mistake was to forget the closeness of the EU Referendum result, at 52% to 48%, and to buy into the soundbite that “We’re all Brexiteers now”. Voters in cities and university towns, which tend to be more global in their view of the world, have reminded her very firmly that this is not the case and have rejected her ‘hard Brexit’ plan. This is seen clearly in London, which voted to remain in last year’s referendum and, when viewed on a political colour map, is now a sea of red.
However, this Brexit factor was not a universal driver, as the Conservatives lost seats in Wales, which voted for Brexit, whilst gaining strongly in Scotland, which was firmly for Remain. This improvement in Scotland, along with gains for Labour and the Liberal Democrats, primarily at the expense of the Scottish Nationalist Party (SNP), may provide the only positive outcome for Theresa May, namely that a second independence referendum for Scotland would now appear to be far less likely.
Aside from the silver lining of a somewhat diminished SNP, the result makes the decision to call the election look extremely ill-judged. Despite it appearing likely that the Conservatives will remain in government with the support of the DUP, Theresa May is certainly damaged by the result. Having made it a very Presidential-style campaign, it is hard to see how this does not make her job of negotiating with the EU harder, especially as the DUP favour a ‘soft border’ in Ireland which would appear to be at odds with her desire to get a firm control on immigration.
So how have markets taken all of this so far? Reaction has been similar to that after the EU Referendum in that it has focused initially on sterling, which fell by over 3 cents versus the US$ before recovering somewhat to trade down just over 2 cents. By contrast, the stock market has risen. This may be the effect of overseas earnings being translated back into a weaker sterling, boosting company profits, and the fact that the large cap focused FTSE100 is up 0.8% whilst the more mid cap focused FTSE250 is in negative territory would seem to back that up. However, after falling 1% at opening, the FTSE250 has recovered most of these losses, so the market may be considering the possibility that Theresa May is no longer in a position to deliver a ‘hard Brexit’.
Consensus is that staying in the single market is good for businesses so, after an initial wobble over the uncertainty that a hung Parliament naturally brings, investors may now be considering a wider range of outcomes and even finding the positives within the result. These positives may include the potential for austerity to be curtailed or even ended, as a minority Conservative government may struggle to get further cuts through Parliament. This would mean Government spending being maintained at higher levels than would otherwise be the case, with the resulting additional stimulus being seen as positive for the UK economy in the short term.
Whilst market reaction has been relatively muted to date, there is no doubt that the result adds another level of uncertainty to the period of Brexit negotiations. This was already likely to be the most important and challenging period in the UK’s history for a generation or more, with the whole process fraught with complexities and pitfalls in what is genuinely unchartered territory. Add to that a weakened Prime Minister, the possibility of leadership challenge from within her own party and another General Election in the not too distant future and it is hard to see that things have got simpler for investors. For now, we remain sanguine about the result as we have been well diversified around such binary political events for some time and will continue to be so. However, the list of what Donald Rumsfeld called the “known unknowns” just got a little longer.
Unlike before the EU Referendum and the US Presidential Election, we made no changes to the portfolios coming into the UK General Election, despite recognising that an upset was increasingly a possibility as Theresa May’s lead in the polls ebbed away. For our sterling-based portfolios, including Smartfunds, we considered the assets most vulnerable to a shock result to be our exposure to UK equities, particularly domestically-orientated companies found predominantly within our mid and small cap holdings. However, we were confident that most of the pain would be taken by the currency, which would benefit our much larger position in overseas assets, which provide an effective hedge against any losses experienced within UK equities. As it is, in the immediate aftermath of the event UK equities have continued to behave in the same manner as did after the EU Referendum, with large caps rallying on sterling weakness and even mid and small caps recovering short term losses rapidly as investors consider the bigger picture.
Whilst global leading economic indicators, including in the UK, continue to point towards expansion, we think any significant weakness in asset prices would potentially offer an opportunity rather than be a reason to panic. This is especially so whilst the real yield on UK equities remains at elevated levels versus UK government debt, where we continue to have negligible exposure. Similarly, the yields available on UK corporate credit offer meaningful value when compared to the risk and reward offered elsewhere and do not cause us any alarm, even with the uncertainty created by the General Election result. Therefore, for the moment, we are maintaining our pre-election positioning whilst we have not seen any significant price dislocations from the result.
Towards the beginning of the year, we hedged out some of our overseas currency risk when we considered that sterling had potentially been oversold. Sterling rallied significantly after we placed that trade and, despite the sell-off overnight, is still above the level that we introduced the hedge. The question now is whether a minority government with a decidedly weaker hand when negotiating with the EU will lead to further currency weakness or if an increased possibility of a ‘soft Brexit’ will lead to sterling appreciating. It is too early to have any strong view but, with the hedge removing some of the volatility that comes from such currency movements and the potential for increased short-term volatility, we are happy to main the position for now.
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