J.P. Morgan Fund Manager

UK election: Certainly uncertain

On 18 April, Theresa May announced plans to hold a snap general election, which initially looked like a path to a ‘guaranteed’ increase in the Conservative party's majority.

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Jun 09, 2017
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The plan was to use the party’s then-enormous 20 percentage point opinion poll advantage over Labour to gain an insurmountable seat advantage in the House of Commons. May had been reliant on a small, 17-seat majority, made up in part of Eurosceptic backbenchers, for support in the Commons. With the polls suggesting a majority of over a hundred seats was probable, it appeared an excellent opportunity to cement a considerably more solid foundation for government and, of course, Brexit negotiations.

Roll on eight weeks and the Conservative campaign has, quite simply, not worked as May had hoped. The initial plan for social care in the manifesto offended the Conservatives’ core older voters. The party then appeared to make a U-turn, but appears to have made a mistake by not making a clear admission that it had made a mistake.  The absence of May at debates also appears to have damaged support for the Conservatives.

May’s oft-stated “strong and stable leadership” started to be called into question, while Corbyn’s pledge for higher healthcare spending, taxing the wealthy and free higher education appeared to have broad appeal.

Still, the scale of the upset was a surprise. With the results largely in, and against most expectations, we have a hung parliament. This is clearly a significant setback for May and the Conservative party, who have won just 318 seats, 12 fewer than previously, and shy of the 326 needed for an outright majority. However, with Sinn Fein winning 7 seats, but not taking them up, only 322 seats are needed for a working majority.

Labour has done far better than expected, winning 261 seats, but is far short of a majority and, with the SNP being hard hit in Scotland, it looks unlikely that the party will be able to form a coalition. Instead, the likelihood is that the Conservatives will work with the Northern Irish Democratic Unionist Party (DUP), which won 10 seats, to form a narrow majority.

May has stated that she will not step down as prime minister, but her position as the leader of the party is under significant pressure. A leadership contest could take up to two months, leading to further delays in Brexit negotiations, which are currently due to start on 19 June. Statements from the EU suggest there is a risk that negotiations will be delayed.

The Brexit position of the government that engages in the negotiations remains highly uncertain. Some believe that the surprise loss of seats by the Conservative party reflects a desire for a softer exit from the European Union than Theresa May has been suggesting. This will be supported by the DUP’s desire to keep the Irish border open, which would be achieved by remaining in the customs union. The other argument is that the leader of the party will be utterly at the whim of hardline backbenchers, exactly what May was trying to avoid by calling the election, thus making hard Brexit more likely. What is certain is that the clock is ticking on the Article 50 deadline and time has already been lost as a result of the election.

Market reaction

One thing we know for sure is that there will be further uncertainty, which has been heightened for quite some time—and markets generally do not like uncertainty. However, since the surprising political events of last year, markets have reacted more positively than many would have expected, providing a reminder of the importance of looking at company fundamentals rather than being unduly swayed by the emotional aspects of politics.

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The election outcome resulted in modest weakness in sterling overnight, but the currency currently remains above the level (vs. the dollar) that it was at when the election was called.

What this means for equity markets is still unclear at this early stage.  However, as seen after the UK referendum, weakness in sterling is likely to be, at the least, a short-term boost to companies generating earnings from overseas.  Overseas earners also benefit from exposure to the expanding global economy. Domestically-oriented companies are likely to be more volatile in the near term because the path of domestic policy is now opaque.

The FTSE 100 has traded strongly since opening, driven by stocks with a high proportion of overseas earnings, such as the mining, beverages and personal goods sectors. This has been partially offset by housebuilding and retail stocks, which have significant UK exposure, and, as a result, were weaker as the market opened.

Initially, the FTSE Small Cap Index was down just 0.5%. Smaller companies have an aggregate geographic revenue exposure of 55% domestic vs. 45% overseas, and the small depreciation in sterling has been the driver of this modest fall. Within the index, domestically exposed stocks are down just a few percentage points and overseas exposed stocks up a few percentage points. Given domestic stocks as a whole have underperformed overseas earners over the last12 months, the reaction is as we would have expected. Trading volumes have also been very thin.

The story is similar for UK mid cap companies. The index was initially off about 0.7%, with outperformance from international-facing businesses (including mining, oil & gas and industrials) and underperformance from domestics (including consumer services/goods and real estate). However, the scale of moves is limited.

From an investment perspective, we will not look to make any sudden decisions until we have more clarity on what the landscape actually looks like.  We will continue to focus on the fundamentals driving the companies in which we invest.

Conclusion: Look past the initial reaction

It is worth bearing in mind that the initial market move, laden with emotion and uncertainty, is often inefficient and does not set the future trend. Investors may recall that in the immediate aftermath of Brexit the market sold off aggressively, before rallying strongly to new highs. The initial market reaction today may not be indicative of the future.

Three important factors are: does this lead to a sustained fall in sterling; what is the impact on the UK economy; and is the global economy strong enough to support the broader index?

The data suggests the answer to the latter is yes. However, the answers to the other two questions are difficult to know, and will largely depend on how Brexit negotiations go. If we have a relatively soft Brexit, sterling will rally and the economy will likely perform well, which will help domestic earnings. If we have a hard Brexit then sterling may fall further and the economy will be under strain. The latter is not necessarily negative for the UK equity market as it is an internationally exposed index, particularly in the large cap space.

What is certain, among all this uncertainty, is that the journey has not ended by a long shot. Markets are now likely to shift their focus to the Brexit negotiations, but this election result seems to have created yet more distractions.

Next steps

  

Callum Abbot is the portfolio manager of the JPM UK Equity Plus Fund. Read more>

  

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Go to the profile of Callum Abbot

Callum Abbot

Portfolio Manager, JPM UK Equity Plus Fund , J.P. Morgan Asset Management

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