UK Elections: Markets May Be Too Complacent

Lack of Fiscal Firepower

Drawing parallels to the 1997 election, when Tony Blair and his Chancellor of the Exchequer Gordon Brown emphasized fiscal prudence in the early years, is relevant. More recently, Liz Truss’s short and tumultuous tenure as prime minister highlighted how bond markets can effectively curtail politicians' fiscal ambitions.

The Labour manifesto lacks radical spending plans, suggesting that its leader, Keir Starmer, and his shadow finance minister, Rachel Reeves will likely maintain fiscal conservatism with debt levels running high.

What Can Labour Majority Mean for the Economy?

A potential Labour majority in the upcoming election could mark the end of a 14-year Conservative rule characterized by Brexit and the cost-of-living crisis. However, with limited fiscal room to maneuver, immediate changes may be modest even with a Labour majority.

Nevertheless, signs suggest the UK economy is stabilizing following a brief recession last year. Forward-looking indicators such as the Purchasing Managers’ Index (PMI) and consumer confidence are improving, while monthly GDP shows positive trends. Although services inflation remains high, easing goods inflation is lowering headline inflation, possibly prompting the Bank of England to consider cutting interest rates, possibly earlier than the US Federal Reserve.

A stable policy stance under a Labour government would likely sustain this economic trajectory, bolstered by long-term tailwinds. With immediate fiscal options constrained, the focus is expected to shift towards supply-side reforms, potentially supporting the UK economy's recovery from Brexit over the long term. Labour may also aim to reduce some post-Brexit trade barriers, reflecting its stance on improving relations with the EU, though such changes would likely take time to materialize. Additionally, Labour plans to increase investments in green projects.

A more commanding lead for the Labour party could, however, leave room for some bold policy moves. The economy remains in need for more significant tax increases to keep its fiscal position sustainable, but significant tax increases may be avoided in the short-run.

UK Equities: Structural Tailwinds

The anticipation of a stable political and policy landscape has kept UK markets resilient amid election uncertainties. Any potential market retreat could present a favorable opportunity to position for the UK economy's ongoing rebound from the challenges of Brexit, Covid-19, the Russia-Ukraine conflict, and the instability under Liz Truss's government, which triggered significant outflows from equities and bonds.

The UK markets are also seeing some safe-haven flows amid the election risks elsewhere in the US and Europe. A favourable policy environment, along with the potential for BOE rate cuts, may offer investors an opportunity to reassess UK equities, where valuations are attractive and return prospects look strong.

The following factors could be key for long-term investors:

• Valuation discount: This has led to MSCI UK trading at a significant discount to MSCI World or other developed markets ex-US as reflected by the MSCI EAFE index.
• High dividend: UK equities offer the highest dividend yield among all the key markets
• Sector composition: The index has a balanced mix of defensive and commodity exposures. While oil and gas companies could feel some pain from the Labour’s green transition plan, they still remain a good hedge against geopolitical risks.
• Low beta: UK equities have a low beta to global equities, suggesting they can enhance portfolio diversification.
• Domestic focus: The FTSE 250 Index has a more domestic focus compared to the FTSE 100. The FTSE 250 comprises mid-cap companies that are generally more oriented towards the UK economy, making it more reflective of domestic economic conditions. In contrast, the FTSE 100 is made up of larger companies that tend to have significant international exposure.

GBP: Threat of ‘Buy the Rumour, Sell the Fact’

Sterling has been the top performer in the G10 FX space due to a stabilizing economy, high yield, the Bank of England's lack of urgency to cut rates, and expectations of political stability. However, this sense of complacency might be challenged if Labour's victory isn't as strong as anticipated. Notably, the Reform UK party has been gaining in the polls. A weaker Labour majority could lead to the market demanding a higher risk premium for UK assets.

Sterling could also face risks if the market's reaction follows a "buy the rumour, sell the fact" pattern post-election. Additionally, there are downside risks for GBP if the Bank of England adopts a more dovish tone in the weeks following the election as the central bank paves the way for its first rate cut.

However, GBP may have room to stay supported against the EUR, particularly if election outcomes in France and UK remain divergent. UK’s political and fiscal stability comes in a stark contrast with unstable dynamics in the Eurozone, suggesting that the path of least resistance for EURGBP in the medium-term could be lower.

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