Janus Henderson Investors: UK election – A Tory win might be good for UK equities, but just for Christmas

Key takeaways:

• Betting markets and recent polls suggest a Tory majority, with a smaller likelihood of a hung parliament. While the polls have narrowed, a Labour victory seems unlikely.
• In the event of a Tory majority, UK stocks could stage a short-term rally, running out of steam early in 2020 on persistent growth concerns and the reality of Brexit negotiations.
• In this scenario, gilts may initially fall but rally subsequently as growth concerns trump worries over fiscal indiscipline.

The forthcoming UK election remains hard to call, despite polls indicating a clear Tory majority. This is partly because recent experience tells us that the polls have lost a lot of their predictive power and partly because unexpected events can derail what appears to be an apparently entrenched winning or losing position. With this in mind, can investors in UK assets set themselves up appropriately to ensure that Friday the 13^th 2019 is not a particularly gruesome one for their portfolios?

The most likely outcome in the election (according to betting markets and recent polls) is, by some distance, a Tory majority, followed by a hung parliament. While the Tory lead has narrowed, the average of the past five polls – at the time of writing – sees the Conservatives with a 10 per cent lead over Labour, and the Liberal Democrats some way behind. This lead would usually equate to a decent majority in the House of Commons of perhaps 20 seats or more.

If, once again, the polls are wrong about the Tories achieving an absolute majority, it seems unlikely that Labour can stage enough of a turnaround to win outright. This would leave us facing the possibility of a hung parliament, with some unlikely coalition combinations, and the prospect of another election probably in short order. The key is that, even if the Tories don’t win a majority and cannot form a government, a Corbyn-led coalition would be limited in its ability to turn any potentially extreme manifesto plans into legislation.

So, given the current expected likelihood of a Tory government, relative to the alternatives, what are some of the potential ramifications for markets?

The currency story

Sterling has been a key conduit for Brexit and election-driven sentiment changes in recent years and we do not expect this to change. This can be seen in the options and futures markets where bets on sterling have ebbed and flowed since the 2016 EU referendum – see Chart 1. Investors remain net short but are considerably less bearish than they were in July 2019.

Although sterling has strengthened, as the threat of a hard Brexit has receded and the Tories have moved ahead in the polls, there is still room for it to move higher if we see a more (perceptually) market-friendly majority for the Tories. However, investors appear fairly neutral, so there is not much scope to see large-scale short positions being unwound.

Our view is that this strength could also prove short-lived in the event of a Conservative victory. While many in the country want some certainty over where we stand with Brexit, we would expect to see concerns re-emerge in fairly short order as the size of the negotiating task ahead becomes evident. If Boris Johnson does indeed rule out an extension to the transition period by the end of July deadline, the risks of another ‘hard Brexit’ scenario at the end of 2020 would also coalesce. Meanwhile, weak macroeconomic data in the UK, driven by a combination of Brexit uncertainty and general weakness elsewhere in Europe, looks well embedded.

The stock market story

The FTSE 100 is massively skewed towards foreign earnings, which would indicate further weakness for the UK’s largest stocks if we were to see a bounce in sterling, however short-lived. Nevertheless, a Tory victory would remove the risks associated with Labour’s renationalisation plans, which we would expect to be positive for UK share prices.

We would anticipate that more domestically focused companies, which are often in the mid- and small-cap space, to benefit from market-friendly policies, particularly on tax. There is also more potential for ‘catch-up’ trades, given that mid-/smaller-caps have de-rated more than large caps, relative to global equities.

However, the strength or duration of any equity rally is dependent on a number of factors. Fiscal stimulus from a Conservative government determined to build positive momentum (or at least offset uncertainty) would be helpful for growth, although stimulus measures take time to filter through into activity data. While the Tories also intend to ‘get on with Brexit’, there is too much uncertainty around the issue to fill the UK’s boardrooms with much-needed confidence, particularly in the services sector.

The fixed income story

Both major parties have promised levels of fiscal spending not seen for decades. The Institute for Fiscal Studies has opined that neither the Tories nor Labour can implement their spending policies without raising taxes (beyond where the latter have already indicated). This likely increase in borrowing and deterioration in the fiscal situation would be a negative for bonds as the UK’s creditworthiness comes under stress. However, we believe that these fears might easily be offset by the safe-haven appeal of government bonds in the face of continuing economic malaise and ongoing Brexit uncertainty. This would suggest an initial fall in gilts, but a subsequent rally as growth concerns trump concerns about fiscal indiscipline.

Inflation-linked bonds will benefit from their long duration if growth concerns persist, but their floating rate features are unlikely to be much in demand, given persistent low inflation globally. Even with very loose fiscal policy on both sides of the political debate, we believe it would take something more akin to an old-fashioned oil shock to light the touch paper under consumer prices.

The most likely scenario, a Conservative majority (if we are to believe current polls), is benign for UK credit too, with rates remaining low but with enough growth to stave off a meaningful uptick in the default rate. We do not anticipate much change in spreads. The main question is whether the low yields on offer can compensate holders for interest rate and credit risk, notwithstanding domestic political noise.