The Outlook: November 2019 economic commentary
UK election 2019 - some key issues for investors
The UK election on 12 December is being seen as a pseudo referendum on Brexit. However, the election result will have implications for a host of other issues that will impact the economic and investment landscape. In this month’s commentary, we take a look at some key issues arising from the election.
Is a no-deal Brexit still possible after the election?
The main political parties have very different views on Brexit. If the Conservatives win the election, they have pledged to pass PM Boris Johnson’s withdrawal agreement, leave the EU by the end of January and then negotiate a free trade agreement by the end of 2020. A Labour victory would see Jeremy Corbyn negotiate a softer form of Brexit – with the UK in the customs union and maintaining a close single market relationship – and then put this deal, along with the option to remain in the EU, to a second referendum. The Liberal Democrats want to revoke Article 50 and remain in the EU, with the Scottish National Party (SNP) adopting a similar stance.
Against this backdrop, a no-deal Brexit is still possible. If the election fails to produce sufficient parliamentary support either for PM Johnson’s deal or another extension of Article 50, the ‘default’ option of leaving the EU without a deal after 31 January could occur ‘by accident.’
However, even with a Conservative majority government, ‘no-deal’ risk would remain. Free trade agreements (FTAs) normally take a long time to negotiate: the EU-Canada trade deal took seven years, for example. However, PM Johnson, under pressure from eurosceptic Tories and the Brexit Party, has ruled out an extension of the transition period beyond December 2020. If a Tory victory leaves PM Johnson dependent on hardline eurosceptic votes and/or Brexit Party MPs, the risk of the UK leaving the single market/customs union at the end of 2020 without a free trade agreement would increase. A Tory majority greater than 30 would give PM Johnson more wiggle room to renege on his earlier pledge and extend the transition period, a request for which must be agreed with the EU by 1 July 2020.
Is the election likely to usher in an increase in government spending?
Government spending seems set to increase whoever wins the election, and the economy is on course to receive a significant fiscal boost. In the spending round back in September, Chancellor Sajid Javid announced a 4.1% real-terms increase in day-to-day spending for the coming fiscal year – the biggest rise in 15 years. As regards investment, the Conservatives are planning a significant unfunded increase in spending. Chancellor Javid’s new fiscal rules will allow borrowing for investment projects worth up to 3% of GDP, well above the long-term average of around 2% of GDP. Javid has said this would allow a Tory government to spend an extra £20 billion a year on infrastructure projects.
Labour is planning an even bigger increase. Under Labour’s proposals, investment would increase by an extra £55 billion a year (around 2.2% of GDP). Like the Conservatives, Labour aims to balance the budget on current spending during the next parliament. However, it plans to fund a huge increase in expenditure with commensurate tax rises: both tax revenues and day-to-day spending are forecast to rise by £83 billion a year. This would result in the state playing a much bigger role in the economy, with government spending as a share of GDP set to rise to 44% in 2023-24 compared with current projections of 37.8%.
There are considerable doubts as to whether the investment plans of both parties will actually be carried out given a lack of ‘shovel ready’ projects and a shortage of skilled production workers. However, on the parties’ current plans, the budget deficit – which has been falling in recent years and stood at 1.9% of GDP for the 2018-19 fiscal year – looks set to rise to around 3% of GDP under the Conservatives and around 4% of GDP under Labour.
How might financial markets react to a Labour victory?
Given the low odds that markets currently assign to a Labour victory, a Corbyn premiership is likely to come as a shock to equity investors. The reaction is likely to be less extreme if Labour can only form a minority government, given that the party’s ‘radical’ agenda is likely to be watered down.
Although Labour’s softer Brexit stance will be viewed favourably by many business leaders, the higher taxes, increased regulation and programme of nationalisation outlined in Labour’s manifesto are likely to offset this and weigh on UK equity markets.
Some estimates suggest that Labour’s proposed increase in corporation tax from 19% to 26% could knock around 9% off post-tax earnings per share for FTSE 100 companies. Labour’s plan to give workers in companies employing more than 250 employees up to 10% of the company’s shares threatens to dilute the stakes of existing shareholders.
In terms of sectors, the utilities, transport and communication services sectors are likely to be hit given the concern over nationalisation. The financial sector would be negatively impacted by the prospect of a financial transactions tax. The energy sector seems set to come under pressure as a result of Labour’s planned windfall tax on oil companies. On the plus side, redistributive policies that benefit low-income households could see retailers and other consumer-facing industries benefit from increased demand. In turn, construction and engineering companies would be helped by increased spending on infrastructure.
As regards the exchange rate, the prospect of a softer Brexit, and possibly even the UK remaining in the EU following a second referendum, might be positive for the pound. However, the chances are that these factors will be outweighed by capital flight due to a less business-friendly environment, concerns over creeping nationalisation and higher taxes. As a result, it seems likely that sterling will fall back.
The impact on the gilt market is perhaps more difficult to gauge. An expansionary fiscal policy, a marked increase in the national living wage and higher bond issuance to fund a nationalisation programme would argue for higher yields. However, if the dominant reaction in response to a Labour government is for the equity market to sell off, gilts could benefit from safe-haven flows and expected deterioration in business confidence. Investors seeking a defensive stance and who are wary of the impact of increased borrowing on the gilt market might take refuge in gold.
What election result appears most likely?
The exceptional circumstances of the current election suggest that predictions based on opinion polls should be treated with a degree of caution. However, current polling suggests a low probability of a Labour majority government, with the Conservatives leading the main opposition party by 12 percentage points. The Electoral Calculus website – which uses quantitative models to predict the number of seats in parliament from opinion polls – sees the Conservative Party gaining 359 seats, which would give the party a comfortable majority in the 650-member House of Commons. Electoral Calculus currently puts the probability of a Tory majority at 74%, with the next most likely outcome seen as a Labour minority government, with a probability of 13%. The probability of a Labour majority government is put at just 1%.
Betting markets tell a broadly similar story, with the PredictIt website attaching an 85% probability to Boris Johnson becoming the next Prime Minister.
Of course, the Labour Party made large gains during the final stages of the 2017 election campaign and the Conservatives ultimately lost their majority. However, PM Johnson is generally seen as a more charismatic leader than his predecessor, Theresa May, and the launch of the Conservative’s ‘play it safe’ manifesto has confirmed that the party is unlikely to make the same mistakes regarding policy proposals.
What might a Conservative election victory mean for financial markets?
Global trends are likely to remain a key driver of UK financial markets, but a victory for the Conservatives could influence performance via several channels.
A Conservative government with a significant majority would foster expectations that PM Johnson’s Brexit deal will secure approval in parliament and the UK will leave the EU at the end of January 2020. The reduced near-term risk of a no-deal Brexit is likely to usher in an upward move in the pound. This said any appreciation will be bounded by the lingering threat of the UK leaving the transition period without a free trade agreement at the end of December 2020.
As regards the gilt market, several factors could put upward pressure on yields. The reduction in near-term no-deal Brexit risk could see safe-haven demand for gilts unwind. Moreover, the prospect of fiscal stimulus, along with reduced levels of uncertainty, could also give rise to an increase in both growth and inflation expectations, which would serve to lift yields. In addition, a wider budget deficit would also bring an increased supply of gilts to the market. Although the Bank of England has sounded more dovish of late, a smooth Brexit could see the market revise up expectations for the path of interest rates going forward. These factors could lead to some underperformance of gilts versus other sovereign bond markets. However, ultra-low bond yields in the eurozone and Japan are likely to serve as an ‘anchor’ for UK yields and work against a sharp sell-off.
Given investor anxiety over the market-unfriendly policies of Jeremy Corbyn’s Labour party, UK equities could experience something of a relief rally in the event of a Conservative majority. In this regard, the utilities, transport and telecoms sectors could see a bounce, as the threat of nationalisation dissipates. In addition, the construction sector can be expected to benefit from planned increases in infrastructure spending.
With UK equities attractively valued versus overseas markets and significantly under-owned by global fund managers, the reduction in uncertainty could give the UK market a boost, as previously underweight international investors reallocate back to the UK. This said an appreciation of sterling would hamper the relative performance of overseas earners, at a time when fiscal stimulus would enhance the prospects of companies that are more dependent on UK domestic demand for their revenues. This would argue for an outperformance of the more domestically focused FTSE 250 compared to the more internationally exposed FTSE 100.
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.