7 minute read
The UK general election confounded the predictions of political commentators and pollsters. Our investment teams assess the potential financial market and economic consequences.
It wasn’t supposed to happen this way. When UK Prime Minister Theresa May called for a snap general election on April 18, she was way ahead in the opinion polls and seemed certain to secure a comfortable majority. The consensus was that a straightforward election victory would strengthen her hand as the country headed into Brexit negotiations with the European Union.
But what appeared a low-risk gamble has backfired, and the UK now has its second hung parliament in the last decade. We ask investment teams across our business to assess the prospects for the economy and sterling-denominated assets, and what the changed political landscape means for forthcoming Brexit negotiations.
We begin by talking to Aviva Investors’ senior economist and macro strategist Michael Grady.*
The result of the UK election is yet another example of pollsters, commentators and markets getting it wrong. Should we be so surprised?
It was pretty clear there was more uncertainty around the opinion polls than there had been in previous UK elections. Traditional voting patterns were expected to be more fluid, making it difficult for the pollsters. That is why there was such a spread of polling views in the days leading up to the election. In retrospect, a couple clearly had their methodology more or less correct, as they were pretty close to getting it right. What certainly seemed clear from all the polling was that support for the Conservatives waned over the course of the campaign, while it increased for Labour.
One leading Tory has said the UK may need to reconsider coming out of the single market and customs union. Is a “soft” Brexit now the most likely outcome?
It is really too soon to say how this will impact the Brexit negotiations. It will depend on many factors, including whether there is a change in leadership of the Conservative party, the potential for another election and how the newly formed government works with the opposition parties. We think the result of the election has increased the chances of a “softer” Brexit, but it is hard to say at this stage for sure, not least because it is a negotiation with the EU. It is not simply in the power of the UK to determine the outcome.
Does the increased chance of a “soft” Brexit spell good news for the UK economy, or is this outweighed by the increased political uncertainty resulting from the vote?
Going into this election we had become increasingly concerned about the near-term outlook for the UK economy. Growth eased back materially in Q1 2017 and early signs for Q2 2017 are not particularly encouraging. Real wages have been squeezed and household savings have fallen sharply. We expect that will result in slower growth of household spending. At the same time, the hoped-for boost to export volumes has not materialized. There is a real risk the increased uncertainty generated by the election, which might be with us for many months, could lead households and businesses to pull back their spending even further.
Sterling has fallen. If we get a soft Brexit, could the currency begin to appreciate from these levels?
The drop in sterling has been fairly modest. We think that probably reflects a modestly higher risk premium given the increased uncertainty. But it is very hard to assign probabilities to either “hard” or “soft” Brexit at this stage. Only once that becomes clearer, which may be many months from now, do we think we will see a larger move in the currency. That could be in either direction depending on the path the UK pursues.
What about the prospects for other financial markets?
Given our expectation for the UK economy to slow further, we expect equity prices of UK-focused firms will weaken relative to the broader market. We would also expect the prospect of rate hikes from the Bank of England to be pushed further out, putting some downward pressure on shorter-dated gilt yields. Markets outside the UK are less likely to be impacted.
It seems like there was a clear vote against austerity, both in London and the north of England. Could the end of austerity be approaching?
The focus had already shifted away from austerity under the Conservative government. The Institute for Fiscal Studies analysis of the Labour and Conservative manifestos showed there was really very little difference in terms of the pace of reduction in the deficit and eventual move into surplus. The Labour manifesto was more about the size and role of government than a change in the cyclical fiscal stance.
Is there any chance we get a complete about-face in economic/monetary policy (i.e., looser fiscal policy combined with tighter monetary policy?)
We think that on the margins there will be increased potential for fiscal stimulus should the economy slow sharply. But we also expect monetary policy to remain very accommodative.
Global markets have largely shrugged off surprising political events in the past 12 months. Could this time be different?
This is very much a UK-centric issue. It’s not necessarily right to say the markets shrugged off the outcome of the EU referendum last year. We saw sterling fall sharply at the time and it remains more than 10% lower than before the referendum. That reflects the market’s view on the longer-term negative impact of the UK leaving the EU. But it probably doesn’t fully price in the negative implications of getting no deal with the EU. That would likely see sterling fall further. By the same token, a deal that allowed the UK to retain access to the single market would likely see sterling rise, perhaps quite materially.
Cross asset-class implications
Charlie Diebel*, Head of Rates
“Uncertainty is the watchword for the UK, with little resolution to political risk in the near term. The take for gilts is likely to be modestly negative as the market will demand a greater risk premium for owning assets with so much political instability attached to them. The market will price in higher yields given the potential for another general election, not to mention increased uncertainty over Brexit talks. There may be a general shift by all political parties towards the center, which could imply a softer Brexit stance is likely, with a potential move to looser fiscal policy. Again, this should result in higher yields and also a steeper yield curve as a result of an increase in gilt issuance.
Overall, market moves will be somewhat contained. The Bank of England will not be moving on interest rates any time soon and, if anything, deterioration in the economy from here could open up the debate for even further monetary stimulus measures being employed.”
James Vokins*, Senior Portfolio Manager, Multi-Strategy Fixed Income
“The immediate reaction in the credit markets was relatively muted, with only minor weakness in UK bank spreads and more cyclical credits. Given the heightened uncertainty, UK and international corporates are likely to use this as another reason to be cautious on investing in the UK, and that should mean protecting their already strong balance sheets – a further support to UK credit.
“The Bank of England has only just finished its corporate bond buying program and could be poised to turn the taps back on if there is any sign of growing weakness in the macroeconomic backdrop. At a sector level, a weaker sterling will once again hit the import costs of domestic industries as well as wider issuers within the retail, real estate and travel sectors, where we remain cautiously positioned.”
Trevor Green*, Head of UK Equities
“Markets hate uncertainty but that is what we have got. One has to be careful about taking strong views on the implications of a hung parliament while there is so much political transition going on. Normally investors pay too much attention towards politics as an influencer of the direction of the economy. Maybe this time it will be different.
“Looking at history as to a guide to what a hung parliament means for the economy is fairly meaningless, as there were different and very specific characteristics around the 1974 and 2010 Elections.
“Lessons can perhaps be learned from short-term market moves around the Brexit vote, where the market got instantly bearish on all things consumer. In actual fact, economies do not change overnight and data remained resilient for the rest of 2016, and the implications of a weaker currency since June are only really being felt now. Weaker sterling has led to the obvious move up in inflation and this has led to the consumer being in a relatively weaker position today than it was in June last year, as wage growth struggles to keep up with inflation and the savings ratio hits record lows.
“On the other hand, as we enter a period of political uncertainty, it is reassuring is that UK employment is at record levels.”
Gavin Counsell*, Senior Fund Manager, Multi-Assets
“Political risk has been a significant factor in markets over the last few years and recent events only serve to increase the uncertainty in the UK. While this is unwelcome over the short term, there are scenarios that could lead to a softer stance on Brexit and more fiscal stimulus, which could both lead to more positive outcomes for the UK economy and risk assets over the longer term. In the context of the global economy, the impact is far less significant and this is mainly regarded as a domestic issue.
The events serve as a reminder of the importance of diversified portfolios and thorough portfolio construction, to ensure robust outcomes for investors. With the impact of Brexit already starting to feed through into the UK economy with slowing growth, rising inflation and falling sentiment, we have been running an underweight to UK risk assets. Instead, we prefer to invest in opportunities to take advantage of the improving growth dynamic and reduced downside risk within European equities.”
UK Commercial Real Estate
Chris Urwin*, Head of Global Research, Real Estate
“It is challenging to identify the specific impact on commercial real estate, other than those that will follow from the effects on the wider economy and other investment markets. Even before the election, the outlook for real estate was challenging. The adjustment necessitated by Brexit has yet to happen. In particular, values of central London offices remain elevated even though there is increasing evidence of softening in parts of the occupier market.
“Economic growth is slowing as consumers come under pressure from rising inflation. These cyclical pressures would likely compound various adverse structural forces currently influencing retail property, such as the move to online sales.
“However, the impact on investors’ perceptions of UK real estate is unlikely to be as dramatic as it was following the Brexit vote in June 2016. That was a definite step into the unknown and investment decisions immediately came under intense scrutiny. There is no sense of panic and it is hard to identify any challenges thrown up by the election that didn’t exist already.”
UK Private Assets
Nikhil Chandra*, Investment Strategist, Global Investment Solutions
“Financial markets do not like uncertainty, yet that is just what this election has delivered. In times of uncertainty, banks tend to retrench from lending and shrink their balance sheets. This may create opportunities for non-bank lenders in terms of extending primary loans and acquiring assets for portfolios at attractive risk-adjusted levels. Furthermore, there may be additional opportunities for origination of infrastructure assets if the political commitment to austerity lessens.
“Irrespective of the election result, institutional investors will continue to seek attractive returns in non-listed assets given the current low yield environment. Private assets offer a number of potential benefits depending on the asset class; including reliable cash flows, inflation-linked income, diversification, downside protection, and access to illiquidity premia. While volatility will almost certainly be a feature of the near-term investment horizon, we are committed to our long-term investment view.”
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