FTSE investors look past election uncertainty

A week has certainly felt longer for Theresa May's Conservatives. 

The five days since a surprise YouGov poll slashed a seemingly unassailable lead against Labour to single digits have been packed with more upsets for the ruling party than apparently possible. The latest YouGov survey, out late on Tuesday, keeps up the pressure. The pollster concludes that the Tories could lose as many as 20 seats and that Labour could gain up to 30, leaving Parliament hung.

The uncertainty can't end soon enough for investors either. The pound remains at the heart of market moves in reaction to pre-election developments, and investors will continue to follow opportunities and risks to major UK stocks from sterling. On Wednesday, an optimistic view of the market was prevailing, despite a wider set of potential outcomes from the 8th June election.

The five main scenarios Britain will face on the morning of 9th June are:

1. A Conservative landslide
2. A bigger Conservative majority
3. A Conservative win, but no gains (meaning a 12-seat majority or less)
4. A hung Parliament (no clear majority for any party)
5. A win for Jeremy Corbyn’s Labour Party

Polls take a toll on sterling

With polls continuing to show no bounce back in the Tories fortunes scenario 1 looks increasingly unlikely. However, case number 4 and 5 also, at this point seem relatively remote. That leaves either a significantly larger Tory majority (2), or a flat-to-slightly lower one (3) as the most realistic scenarios.

In either of the least dramatic scenarios, the path for the pound back to last week’s eight-month high of $1.3048 could be a slow, or even a tortuous one. However this might be a tailwind for FTSE 100 blue chips which have, since the Brexit vote, been in higher demand whenever sterling has struggled. It’s due to perceived benefits for the giant exporters listed on Britain’s flagship index.

In either of the likeliest cases, we could expect bargain hunters, looking to pick up stocks that could A. continue to benefit from a business advantage due to weaker sterling, or B. sectors neglected since the Brexit vote due to greater reliance on sterling.

A. For this category, we note that time and time again, investors have proved their appetite for the largest exporters on the market, including the heaviest FTSE weights, HSBC, Royal Dutch Shell and BP, almost regardless of internal or external challenges. The latter stocks are 51%, 13% and 20% higher since the Brexit vote. Unilever has added 33%.

B. Among relatively neglected sectors, we include retailers of all kinds like Sainsbury’s, Tesco, Carphone Warehouse; perhaps particularly Next Plc., Dunelm and others that have flagged their need to hike prices to offset rising input costs. And whilst the property sector looms large under any political scenario, we think a strengthening pound would favour the commercial property stocks. Almost all are Real Estate Investment Trusts, or REITs, and offer better bargain potential than house builders since most of the latter have surpassed pre 23rd June prices.

REITs stand to benefit from an eventually stronger pound, and from softening gilt yields that would increase the relative attraction of yield returns from REIT net asset values. British Land and Land Securities are Britain’s biggest commercial developers. They’ve gained a paltry 4-7% since 24th June 2016, despite their profits having risen in recently reported financial years. As stated, we do not rule out extension of the significant gains since the Brexit vote for large housebuilders like Barratt Development and Persimmon. Rightly or wrongly, investors in residential property continue to look past signs that more than half a decade of steady price rises—particularly in London—are coming to an end.

In May, the Halifax house price index saw its first quarterly fall since November 2012. Still, huge government funding schemes to bolster property development have opened a pathway for continuing revenue growth for many housebuilders, albeit it’s telling that developers most tilted to London, such as Berkeley Group have underperformed. For the time being, investors seem to be expecting the property development market to slow, rather than reverse and that will keep most residential property shares attractive.

Bargain hunt

Only in the very worst-case scenario—from the market’s point of view—a win by Labour which would upend both the pound and broad stock market sentiment too—could we see a significant equities correction. It could possibly be as sharp as the one that followed the Brexit vote. Several FTSE shares fell by double-digit percentage amounts on the day after the referendum vote. Even then, as shown by the rebound of most stocks in the weeks and months that followed, blue chips are likely to be resilient as anxieties ease.

The second worst-case scenario—highlighted by Tuesday night’s YouGov poll suggesting a hung Parliament—could, after all, have pragmatically positive implications for the Brexit process. Better checks and balances against a hard Brexit could be possible. Probabilities still tend to exclude the unknown quality that is Labour’s leadership being in the driving seat, but even if Labour wins, a softer Brexit would still be likelier, and the market has made plain that it prefers soft to hard. On the other hand, even a hung Parliament is still a remote outcome. The most likely result is still an improved Conservative majority. The risks to that scenario are around the extent of the Tory win.

Either way, we’re also mindful that ‘shock’ poll results in the run up to the general election are beginning to show ‘diminishing returns’ in terms of the stock market’s reaction. Note that both the FTSE 100 and the FTSE 250 rose on Wednesday. Their gains didn’t provide much to write home about at the time of writing, but the upticks did suggest that investors were buying despite increasing uncertainty and regardless of political risks to the investment outlook.

The sterling market reaction has been pretty much what we have come to expect. The pound remains highly sensitised to Westminster and the softer pound has again helped to buttress export-dependent stocks. Still, the participation of the more sterling-exposed UK markets in mild gains on Wednesday—FTSE 250, FTSE Small Cap and most FTSE AIM indices—points to steadying investor sentiment across the board.

One additional risk to large equities needs to be considered: the flattening gilt-yield curve. This happens when longer-term and shorter-term borrowing costs both fall to a similar level, making it increasingly difficult for financial companies (namely banks) to profit from ‘borrowing short’ and ‘lending long’. This has begun to eat away at bank investors’ confidence in the U.S.

It’s difficult to dismiss this risk in principle, however it’s worth noting that the main conduit to the UK stock market from gilts—the banks—have either already significantly underperformed the market so far this year (e.g. Barclays) or have survived and modestly thrived on meagre net interest income growth for years (Lloyds).

All told, there are increasing signs that investors have assessed risks from a more uncertain election outcome as contained, and are reacting accordingly. We expect this to largely remain the case till Election Day, though stocks could certainly cool off a bit more as we get nearer 8th June.