UK election – it is tough to trade consensus outcomes

The UK general election this week has been touted as the most momentous election since the Tories swept to victory in 1979 under Margaret Thatcher. Whether that is a fair characterization is debatable as it is the third election in less than five years, with all of those elections directly linked to the real earthquake: the Brexit referendum of 2016, which was held due to a platform promise of David Cameron’s 2015 election campaign after his attempts to renegotiate the terms of the UK relationship.

Anyway you turn it, though, the election will prove a pivotal test of the expectations for the UK economy, financial markets and the pound sterling, as the bulk of the uncertainty that has dragged on endless since the June 2016 referendum will lift – even if some longer term uncertainties remain.

First, we write this with the overriding assumption that the strong consensus around the election’s outcome is correct and that the Conservatives under Boris Johnson emerge victorious with a clear majority in Parliament. A recent poll by Lord Ashcroft Polls buttresses our conviction: when asked the question “If you had to choose, which of the following would you prefer?” – the two options being “A Conservative government with Boris Johnson as Prime Minister” and “A Labour Government with Jeremy Corbyn as Prime Minister.”, fully half of pro-Leave Labour voters said they would vote Boris.

Assuming a clear Conservative majority government post-election, some likely positives for the UK economy and sterling are:

• Inbound investment flows – the clarity provided by a post-Brexit landscape and a clear majority government with a strong mandate and telegraphing a clear message on policy should encourage strong investment inflows
• Fiscal stimulus – fiscal austerity was already declared dead under Theresa May and now Boris Johnson has declared an intent to boost spending and reduce taxes, even as current Chancellor Javid has touted. The latter is likely pure fiction as we are convinced that at near-zero and negative rates worldwide, nearly every government is set to expand fiscal spending. So, while Johnson’s spending promises look modest now, we suspect a Johnson government will get far more aggressive on stimulus – both in terms of tax cuts and spending in light of weak UK economic data into year end. 
• Deregulation lite – most of the Boris Johnson focus is on social spending in the campaign period to yield the most votes on election day.  But it would be a surprise not to see more of a focus on deregulation where possible from the pro-business Johnson to invigorate the private sector from the supply side as well. Already, Johnson has promised a focus on ending property taxes for businesses and there could be a lot more here.
• Avoiding Corbyn / hung parliament – polling all along has suggested that the odds of a Labour government are virtually nonexistent, but still, there is some residual uncertainty at the margin on the risk of a hung parliament scenario dragging out the Brexit process. The lifting of this final shred of uncertainty is a positive, all other things being equal. A Brexit No Deal risk is simply not on the table in our view, nor is a Remain referendum.

Possible Negatives for the UK economy and sterling relative to expectations:

• Too little, too late? – The UK economy is in a pretty parlous state and limping along with a weak 1% growth rate and the fiscal package Boris Johnson has outlined thus far looks like a pale imitation of the kind of support that US President Trump brought to the table in 2017 for the US  economy. The spending promises are generally focused on health and education, which are not areas that improve productivity even if any spending into these sectors will boost wages and consumption. If we don’t get into fiscal expansion mode far beyond what is on the table, the UK economy is set to perform weakly.
• The damage done – the uncertainty of the Brexit period has eroded the UK economy over the three and half years since the referendum, with major banks already relocating considerable operations back to the continent to ensure continuous operations post-Brexit (and on the periodic fears of No Deal contingency plans) and a couple of EU agencies currently in the UK will also relocate. These jobs will not be coming back.
•  Twin deficit woes – while fiscal stimulus is normally a positive for a country’s currency, it does require offsetting capital inflows to finance the budget shortfalls and the currency will weaken to compensate for insufficient inflows. One of the most remarkable things over the entire decade since the global financial crisis is that the collapse in sterling, first after the GFC, and then after the Brexit referendum, hasn’t seen an improvement in the UK’s current account deficit, which still stands around 5% of GDP. The UK needs to attract a new kind of investment away from London and financial services and find new export industries if we are to expect an economic Renaissance. In a world at risk of deglobalizing, we may have already seen Peak London.
• Uncertainty over shape of longer term trade deal – let’s remember that the Brexit deal doesn’t cover the final terms of the UK-EU trade relationship – the uncertainty there could prevent major companies from locating operations in the UK. One example was Tesla’s decision to locate a factory in Germany rather than the UK, explicitly due to Brexit uncertainties. So, accomplishing Brexit on paper doesn’t remove all of the uncertainty.
• Existential UK concerns – we are not particularly concerned that Scotland and especially Northern Ireland have any reason to break. If they were to do so, it would be egregious economic self-harm as both regions are dependent on massive fiscal transfers from the UK budget – Scotland to the tune of 7% of GDP and the basket case Northern Ireland economy is far above that and had the highest level of public spending per capita of the entire UK in 2018.
• With or without Brexit, still an EU regulatory straitjacket – the EU will not treat kindly any UK attempts to sharply alter policy norms on regulation and trade and use inevitably use this as leverage on the still-undecided trade deal. Thus, the real leeway for the UK to goose growth from deregulation and other policy efforts may prove very constrained.

Much ado and then ho-hum after the December 12 UK election?

As you can see from our above list, the chief support for sterling and the UK economy is that simply knowing the rules of the game in a smooth Brexit process and the lifting of the hung parliament /Corbyn risk could provide considerable relief and bring a flurry of activity on the end of pent-up investment decisions. But the dream of the most ardent conservative Brexiteers, that Brexit would allow the UK to become a free-trading, “Singapore-on-the-Thames” will not obtain in any meaningful way. In short, our general sentiment is that the positive expectations are a bit over-hyped and that hopes for sterling and the UK economy could find a ceiling very quickly after Brexit. If we have mis-gauged the situation, the initial pop higher in sterling could extend beyond the 3-4% maximum potential we expect. On the flip-side, if the UK stumbles along with weak policy initiatives and the global economic backdrop proves unsupportive and weak, the BoE might have to step in to fund budget shortfalls and the ongoing twin deficits could keep sterling mired at the weaker end of the range for a year or more to come.

Sterling and UK equity outlook and trading stance around the December 12 election

Sterling upside – the risk/reward does not look compelling for those looking for a further sterling rise in the immediate wake of the election as the consensus is quite strong on the outcome and traders already long sterling might look to take profits quickly or sell call options against long position. Given our “damage done” argument from above, we would argue that sterling’s range has been set permanently lower, so EURGBP downside potential may not extend much below 0.8000 even longer term barring an EU crisis.

Sterling downside – It is far more straightforward to trade an options scenario for a negative sterling outcome, either because the market decides it has excessively priced for a strong reaction to the expected outcome, or because uncertainty quickly settles in after the election on the longer term  questions for the UK economy.  Before the election, put spreads offer the most attractive risk/reward for sterling bears because the low-delta puts are very expensive (high implied volatility with very negative skew, especially for disaster insurance). Sterling doubters waiting until after the elections may look at simpler, vanilla puts in GBPUSD or calls on EURGBP for the two-three months down the road.

UK equities – Equity markets are difficult to predict and it’s not any easier during critical events such as the UK election on Thursday. In the case of a substantial Conservative majority the initial reaction would most likely be positive for UK equities broadly on the day as Corbyn’s clear anti-corporate plan is avoided. But investors will quickly realize that the big hurdle of negotiating the actual post-Brexit trade deal with the EU, is still ahead.

Within the scope of a stronger Conservative government we see fiscal spending increasing which would be positive for domestically oriented companies such a local banks, mid-caps (FTSE 250), homebuilders, utilities and retailers. This would fit with the market reaction we have observed over the years as Brexit news have ebb and flowed. On the losing side, exporters heavily dominated by pharmaceuticals would be hit by a stronger GBP.

Longer term, assuming a Brexit deal, UK companies will operate under a post Brexit world in which it is impossible to predict how UK equities will behave relative to elsewhere. However, since the 2009 UK equities have only marginally underperformed European equities in EUR terms and there is nothing to suggest this trend will change after a Brexit. UK equities look attractive with a 5% dividend yield, although it comes with a lower earnings growth rates and the UK equities market (FTSE 100) is heavily dominated by financials, energy and materials companies, with only 1% of the index coming from information technology which is where the large growth is coming from in the coming decade. In our view UK equities are not a straightforward country play so in general we favour a stock-picking approach in the UK equity market rather than exposure to UK indices.

-  John J. Hardy and  Peter Garnry