UK general election: a brief sideshow ahead of Brexit negotiations

A decent majority for the Conservative Party of 50-plus seats may produce a short-lived rally for UK stocks while more dramatic swings might be expected in the event of an unlikely Labour victory, but Brexit would continue to cast a pall.

Sterling is having a tough time as polling day in the UK draws closer. Amid evidence that the Conservative lead over Labour is shrinking, the fall in the pound reflects concern the party led by Theresa May may not quite achieve the overwhelming majority it needs to play a strong hand in the Brexit negotiations – this, at a time when the UK economy is showing signs of slowing down. Instead of the 100 plus majority some thought the Conservative party could achieve, markets, in our view, are clearly pricing in something more modest – a majority of 50 seats or more. And there is still plenty of time for that lead to shrink further.

The damage, in our view, is somewhat self-inflicted. The Conservative manifesto is unusual in that it includes little in the way of policies that would usually appeal to the party’s traditional heartland. It has left open the possibility of tax increases and its proposal to make the elderly pay for their own social care seems like a serious misstep.

The Labour Party under Jeremy Corbyn has, on the other hand, delivered a manifesto that has direct appeal to its core voters. It will likely galvanise the Labour leader’s supporters, and ensure a high turnout in his favour on election day. In short, we are now set up for a tighter race than might have been expected at the beginning of the election campaign.

Keep an eye on sterling

That said, it still appears that Theresa May and her party are likely to find themselves with a bigger majority than the one they had previously. Markets, in our view, will react positively to the news, and sterling should strengthen a little. The knock-on effect, from a stock perspective, might be a modest rally in the shares of companies that do most of their business here in the UK. The post-Brexit decline in the pound has raised the cost of imported raw materials many of these companies need to produce the goods they sell to us, and there has been pressure to pass on these higher costs to the final customer. A rising pound might shield the UK consumer from these rises at a time when incomes are seeing a real squeeze. We would caution, though, that the pound’s gains may be modest – no more than a 1%-2% rise on a 50-plus majority for the Conservatives, perhaps 3%-4% if it’s a more decisive win. Then again, it is important to remember that weak sterling has been a boon for UK-headquartered multinationals like Unilever where overseas earnings earned in euros or dollars, have boosted balance sheets due to the favourable exchange rate.

In the event of a Labour Party victory, the direction of sterling is less clear. We could see a “Trump effect” where the likelihood of increased government spending takes pressure off the Bank of England, pushing short interest rates higher on the expectation benchmark interest rates will also start moving up sooner than initially thought – such a move would likely strengthen sterling. As a counterbalance, potential inflationary pressures linked to Corbyn’s policies, and general uncertainty on how a Labour government might proceed would likely weigh.

Wishful thinking

And therein lies the problem, in our view. It is not clear how Jeremy Corbyn is going to generate the additional tax receipts to balance the extra government spending he envisages. Labour has pledged to raise tax on high earners, but history tells us that the hoped-for additional revenue often doesn’t materialise as people re-organise their finances to shield their earnings. This is what happened when the former chancellor George Osborne took the top rate of income tax to 50% from 45% – tax receipts did not go up significantly.

As for raising corporate tax, such a move might prove counterproductive at a time when we are preparing our exit from the European Union. In the current environment, there needs to be an incentive for businesses to continue to relocate here, and raising corporate tax does not, in our view, send the right signal. Talk of implementing a financial transactions tax is similarly unhelpful given the threat Brexit poses to the country’s financial services industry.

In for a hard landing

For business, and for us as investors in UK business, the key focus for both parties should be to lay out a roadmap to help navigate the potential minefield that is Brexit. We believe that a “hard Brexit”, where we are no longer in the customs union, is the likely outcome of any negotiations led by a Conservative government that has been returned to office. The sooner we know what the rules of the game are for future trade with the rest of the Europe, the better it is for everyone. The recent wave of populism that has seemingly engulfed many Western developed nations has been a deeply de-stabilising factor for business. Whichever party wins power needs to create a narrative that is more constructive around business and that involves creating a framework that is going to make the UK a more attractive place to do business.

Would the Labour party be in a better position to create such a framework in the event of victory? Unlikely. On Brexit, a new Labour government would be starting at square one. They would, in our view, have even less time to negotiate a good deal for the UK than the Conservatives even if they were able to take advantage of all the hard work already carried out by the civil service to prepare for the Brexit talks. The best we could hope for would be a decent transitional deal, and we believe, that is also the likely outcome of any Conservative negotiations, although one would hope that Theresa May’s party is a bit further down the line when it comes to understanding what they hope to achieve.

In short, the outcome of this month’s general election does little to alter our view that the companies we invest in need to prepare for the UK’s full exit from the European Union. Transitional arrangements where we see trade deals on a sector-by-sector basis may soften the blow; a full customs union however looks unachievable given the EU’s insistence that full freedom of movement for its citizens remains a condition sine qua non to obtain that privilege.

 

Alastair Gunn and Rhys Petheram are fund managers at Jupiter Asset Management

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