The UK election is now fast approaching with voting on Thursday 12th December. We have summarised our thoughts on the implications of various possible results and then followed this with what happens to the UK under various Brexit scenarios.
A close election result?
Opinion polls suggest the Conservatives have a healthy lead over Labour. However, there is a degree of scepticism around polling given the large number of undecided voters and the poor track record of polls ahead of recent UK elections.
There is also the threat posed by the Brexit Party led by Nigel Farage albeit this now appears to be a bigger threat to the Labour party.
Polling (as at 6th December)
Our view on the impact of various election results
A Corbyn Labour government?
One of the widely quoted risks to investors seems to be a Corbyn government. It is easy to build an ugly investment outcome here (higher taxes, mass nationalisation, increased deficit), and we are mindful that the media will take full advantage of this fear-driven sentiment.
In a note to clients, Morgan Stanley said the prospect of Corbyn becoming PM is a more serious threat to British business than Brexit. Investors should ignore any sector where there’s a threat of interventionism. That includes utilities, public transport and infrastructure companies.
Shadow Chancellor John McDonnell has already admitted we would see a run on the pound should the Labour party gain power.
One would also expect gilt prices to fall dramatically as government borrowing rises sharply. Combined with another fall in the pound, the ultimate result could be stagflation, a combination of a weak economy and high inflation.
A hung parliament is not our central case, but in this scenario the pound would almost certainly weaken. A weaker pound, as has been the situation since Brexit, would mean higher prices for UK consumers and so weigh on already weak retail sales. It would also suppress profits for companies that buy from overseas and sell domestically, which is the position for many retailers. It would mean that large multinational companies outperform smaller companies that tend to be more domestically focused. UK shares should generally underperform overseas stocks.
However, we doubt the market reaction to a hung parliament would be as extreme as when the UK voted to leave the EU in 2016. The UK went into the referendum with a reasonably expensive currency whereas now the pound potentially has less far to fall.
A Conservative majority?
If the Conservatives win a majority, as currently predicted by polls, the Conservative government should be able to push their latest version of the Brexit deal through the legislative procedure with little resistance.
Our expectation is that the pound would remain weak. The harder the Brexit the worse its performance versus the US dollar. Equities would probably rise, more in relief, than in a change in fundamentals. Gilt prices would probably remain under pressure as government borrowing rises.
However, other results could deepen the uncertainty over the direction of Brexit. One potential outcome is a coalition of Labour, SNP and Liberal Democrats forming in support of a second referendum, including an option to remain within the EU, and potentially another general election after that.
For the economy, a smooth Brexit with a transition period removes a great deal of downside risk for the UK economy.
Brexit and future economic growth in the UK
Real GDP growth in the UK under different Brexit scenarios (2019 = 100)
Source: Institute of Financial Studies (IFS)
Whether, and if so how, the UK leaves the European Union will be perhaps the key determinant of UK economic growth over the next few years.
Our base scenario, the UK continues to delay Brexit.
In this scenario, the Institute of Financial Studies assume a further fiscal loosening of between 1 and 2% of GDP. There would be a chance of small rate cuts. Growth remains below 1% in 2020 and, while it then picks up, it remains very poor, below 1.5% in 2021 and 2022.
Securing a Brexit deal would be better for the economy over the next two to three years than another delay.
If this were to come with tax cuts and further spending increases together worth 1 to 1.5% of GDP, then growth should pick up to (a still poor) 1.5% a year in the short term. Some pent-up investment should occur, and consumer confidence would improve, as the risk of a no-deal Brexit recedes.
A ‘no-deal’ Brexit would, economically, be considerably worse
We assume this would happen under a Conservative-led government, which would implement further fiscal loosening totalling 2% of GDP. Interest rates are cut to zero alongside £50 billion of quantitative easing. Private consumption and investment growth falls while net trade is also a drag on growth. Overall, the economy does not grow over the next two years, and grows by just 1.1% in 2022, leaving it 2.5% smaller in that year than under our base case.
Revoking Brexit would lead to the best economic outcome.
We assume this would require a Labour-led government which, as well as revoking Brexit, would also implement significant tax and spending increases, an overall fiscal loosening and some tightening of labour market regulations. Interest rates would also rise more quickly. This might result in growth of 2% a year. Crucially, this scenario involves a Labour-led coalition rather than a majority Labour government.
In the short term, implementation of the full 2019 Labour manifesto would offset at least some of the economic benefits of remaining in the EU. Widespread nationalisations, handing 10% of share capital of large companies to employees while redirecting some dividends to the Treasury, or other policies that might reduce private sector investment significantly, would challenge the UK’s traditional ‘business model’ and risk damaging growth by an amount it is not possible to quantify. Unlike Brexit, at least some of these policies will be reversible under future governments.
Our Portfolio Positioning in UK Assets
Equities: We remain underweight UK equities, relative to our longer-term strategic asset allocation and have a preference for larger UK companies, partly because of the in-built currency hedge they provide, given their greater international exposure. For the time being, we continue to see the threats associated with the Brexit negotiations and upcoming election as outweighing the valuation and yield attractions of UK equities. We expect to remain underweight UK equities until we have a better understanding of the UK’s future relationship with the EU.
Bonds: We hold very little in UK Government Bonds having halved clients’ exposure to Index-Linked Gilts in 2017 and trimmed again in September this year. We do not hold any conventional UK Government Bonds.
Commercial Property: We continue to hold some UK specialist commercial property which provides a high yield and is not particularly economically sensitive. The threat of a Labour government has meant we are watching our healthcare property fund should the threat of nationalisations increase.
Infrastructure: Much of our infrastructure exposure is overseas but we continue to monitor the threat of a Labour government on more politically sensitive assets such as hospitals and schools.
In conclusion we watch this election with interest and with the result too close to call we have positioned portfolios reasonably defensively with regard to UK assets.