As a result of growing voter disillusionment, the chances of majority Labour or Conservative victory seem very low which means that not only is political uncertainty on the cards, but no doubt market volatility if bartering over coalition agreements between the major political parties and likes of the Liberal Democrats, SNP, UKIP, Ulster Unionists or Plaid Cymru were to drag on.
There is certainly room for volatility in markets as well, given that the FTSE 100 recently broke through its record high and is now trading around the 6,800 level while 10-year gilt yields are near their historic lows at just 1.5 per cent.
A number of industry experts have warned that UK investors are in for an unpleasant time as result of the election uncertainty, but in this article we take a closer look at BlackRock Investment Institute’s “Ruling Britannia: UK 2015 Election Preview” note which outlines the key post-election scenarios and their implications they could have on an investor’s portfolio.
Prepare for inevitable price swings
Firstly, the team at the BlackRock Investment Institute hold the consensual view that the most likely outcome is a weak coalition government – either a Labour-led coalition with informal support from the SNP or a less stable repeat of the current alliance between Conservatives and Liberal Democrats.
Either way, the paper suggests that market volatility is almost a certainty because of it.
“A soothing outcome for markets is hard to imagine,” the paper said.
“Labour would be tough on business – and might be perceived as lacking fiscal responsibility. A Conservatives-dominated cabinet would pave the way for an unsettling referendum in 2017 on the UK’s EU membership.”
There isn’t any breaking news in that conclusion, but the BlackRock Investment Institute suggests that the market still isn’t pricing in the chances of politically-induced asset price falls.
“Forming a coalition will be difficult and the possibility of a weak and unstable government is high.”
“What does this mean for markets? Credit default swap spreads have been pretty stable, suggesting little political risk has been priced in. Implied three-month volatility in sterling, however, has spiked – just as it did ahead of the 2010 UK election and the 2014 Scottish referendum.”
Relative 3 month sterling implied volatility
Source: Blackrock Investment Institute/Barclays/Bloomberg
“Even more telling: relative sterling volatility (adjusted for currency market gyrations such as the effect of the slumping euro) recently exceeded levels reached ahead of major political events in the 2000s, Barclays research shows. We expect volatility to stay high.”
Foreign investors start pulling their money, causing gilts to correct
The paper notes that the fiscal credibility of any new government will loom large for the sovereign debt market.
Investors will be well-aware that UK government bonds have had a phenomenal run since the start of last year, with the average IA UK Gilts fund returning close to 20 per cent and comfortably beating equities in the process.
Performance of sector and index since Jan 2014
Source: FE Analytics
While inflation is running at 0 per cent and the chances of an UK interest rate hike over the short term seems unlikely, many market commentators have warned that the gilt market is overvalued with 10-year bonds yielding just 1.5 per cent.
While the BlackRock Investment Institute says that the market hasn’t priced in a huge fiscal risk premium, it says investors should expect yields to rise over the coming few months.
“Volatility spikes can be fast and furious. Could markets be too complacent? We think so. We do not see the election posing long-lasting credit risk to owners of UK sovereign debt – but we do brace for volatility in the short term.”
One of the major reasons for this, according to the paper, is because foreign investors may look to other “safe-haven” markets rather than hold gilts through the election uncertainty.
“Demand from overseas investors may temporarily decline if the election outcome is uncertain or results in a weak government. Foreigners own 28 per cent of outstanding gilts. This could pressure short and medium-dated gilts (where overseas participation is more pronounced), and slow down foreign direct investment.”
“Possible result: a weaker currency because the current account deficit needs to be financed by foreign inflows.”
However, the paper doesn’t expect a prolonged bear market in gilts.
It says that there will still be demand from UK pension schemes and because all parties except the SNP are aiming to reduce the deficit, the chances are there will be slower growth in the issuance of gilts. As a result of those two reasons, the group says a lid will be kept on rising yields.
In the corporate bond market, the paper shows that yields on UK credit have widened recently due to the uncertainty and could continue to over the coming months. However, it says if prices were to fall dramatically, the chances are that European investors will return to the UK given the low yields on offer on the continent.
Equities are also likely to fall
BlackRock expects equities to fall as well, however not necessarily for reasons regarding the bond market, as if the FTSE were to sell-off it could be due to a fall in consumer confidence more than anything else.
“If history is a guide, UK voters should brace for higher taxes in the year ahead. New governments tend to front-load unpopular measures such as tax increases and spending cuts early in their terms,” the paper said.
It goes on to say that certain areas are likely to be hit more than others.
“Smaller companies are likely more vulnerable to a dip in consumer confidence after the election. UK small cap equities rely on the domestic economy for 71 per cent of their sales, compared with just 24 per cent for large caps.”
Performance of indices over 1yr
Source: FE Analytics
Smaller companies have underperformed the wider market over the past 12 months, but many experts now say they are good value for long-term investors and the paper points out that price falls are only likely to be short term in their nature.
The paper says that certain sectors within the UK equity market will be in the limelight during and immediately after the election.
The industries which could come under pressure if Labour were to lead a new government, according to the research, are utilities (due to the pressure to lower prices), bus and rail (due the possible government-backed bidders joining the franchising process) and retail (as profitability could be hit if Labour were to raise the minimum wage).
It notes that banks could come under pressure either way due to increased competition if Labour were to win or the increased chance of a “Brexit” if the Conservatives were to remain in control.
There are areas, however, that the Blackrock Investment Institute thinks look attractive no-matter what – such as housebuilders.
“Schemes such as Help to Buy could be extended. Increased supply of housing is likely, with Labour talking about a target of 200,000 new homes a year,” it said.
Recovery in property market could be hindered
Despite the positive outlook for UK housebuilders, the paper suggests that property prices – both commercial and private – could be hit in and around the election date.
“Election uncertainty could temporarily sap the UK property market’s strength as tenants and developers defer major decisions until a government is formed. This effect should be fleeting.”
“Fiscal austerity proposed by the Conservatives would likely hit areas outside the affluent south-east because government spending underpins a much greater share of employment there. The party’s plans to make Manchester into a ‘Northern powerhouse’ may partially offset this.”
“Labour’s proposed ‘mansion tax’ on high-value residential properties would mostly affect central London, a sector few institutional investors are invested in. Plans by Labour and Liberal Democrats to boost government spending would support regional markets. Yet this could come at the cost of higher bond yields and mortgage rates.”
Investors in UK commercial property have had a fantastic time over recent years as improving economic conditions, along with very low levels of yield available from cash and fixed income assets, has meant the income-paying sector has delivered strong returns due to the increased demand.
According to FE data, the average IA direct commercial property fund is up a hefty 26 per cent over two years beating both bonds and equities in the process.
Performance of funds versus indices over 2yrs
Source: FE Analytics
However, the paper warns that one election outcome could put the rally at risk.
“Uncertainty surrounding the UK position within the EU could dent demand for office space from global companies in the long run. The greater the share of the vote obtained by UKIP and the Conservatives, the greater the impact.”