Head - EMEA Investment Strategy
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UK political instability may intensify in the coming months. We call for caution on UK assets.
The European Parliamentary elections in the UK in May showed support shifting away from the traditionally dominant Conservative and Labour parties. The ruling Conservatives are haemorrhaging support to the insurgent Brexit Party because of their government’s failure to deliver Brexit three years after the EU referendum. The opposition Labour Party is haemorrhaging support to the Liberal Democrats owing to the former’s equivocal stance on Brexit and the latter’s clear opposition to Brexit.
In the coming weeks, we conclude that two things will likely happen. First, the Conservatives will probably elect a new leader with a hard-line stance on Brexit, who can convince Conservative parliamentarians and party activists that he or she can woo supporters back from the Brexit Party. Second, the Labour Party will move more decisively towards opposing Brexit in an effort to regain voters lost to the Lib Dems.
A new Conservative leader is due to be elected by 22 July. Once installed, the winning candidate is likely first to attempt to renegotiate the UK’s existing withdrawal agreement with the EU. Mr Barnier, the EU chief negotiator, has stated repeatedly that changes will not be possible. The best that the new UK PM might secure is likely to be an enhanced political statement accompanying the withdrawal agreement. The PM might then have to present the existing deal once more to the House of Commons, following its three previous defeats. Assuming the same parliamentary make-up, it would probably get voted down again.
With the new PM likely having won the Conservative leadership by promising to exit by 31 October with or without a deal, and with the House of Commons already having indicated its opposition to a ‘No Deal’ exit, a fresh crisis would ensue. The new PM would be unable to implement his/her Brexit plan. The PM could then seek a snap general election to break the impasse or face – and lose – a parliamentary vote of confidence, also leading to a snap general election.
Were there to be a snap general election, it would be fought over the issue of Brexit. A Labour victory would pose additional economic risks. Their socialist programme could include increases in both corporate and personal taxes as well as nationalization across several sectors, including the national electricity grid, water companies, the postal service, and the railways. That said, Labour might well fail to win an outright parliamentary majority, forcing it into coalition with partners that would water down its economic policies. Even so, it would at the very least cause a slowdown in foreign direct and portfolio investment as well as further falls in domestic business confidence and investment.
All of the risks for the UK come at a time when global trade tensions are rising and the UK economy is vulnerable. So, how to position portfolios amid the ongoing uncertainty? The UK newsflow is fluid and the economic and political situations are highly fragile. We thus continue to advocate a short-term trading approach to these markets, based on actual developments rather than on speculation. We expect further short-term Sterling weakness as Brexit faces the two possible extreme outcomes of ‘No Deal’ and No Brexit. While $1.25 is the next likely support level, a growing likelihood of a snap general election ahead of either Brexit alternative would probably take Sterling lower than this. The cheap real exchange rate is only a secondary factor until the UK political backdrop stabilizes.
In the short-term, UK gilt prices could rally further and thus yields fall in line with the global sovereign bond rally. However, there are medium-term concerns, not least that of a Labour government that might raise fiscal spending at a time when the UK still has a fiscal deficit equivalent to 1.1% of GDP. UK equities’ average price/earnings multiple of 12 and dividend yield of 4.9% look attractive. However, we don’t advise buying the market given the uncertainties over Brexit and domestic politics immediately ahead.