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CIO Weekly View | 11th June 2017
Gary Dugan | Chief Investment Officer – Wealth Management | Emirates NBD
THERESA MAY’S DISASTROUS GAMBLE
The UK is facing the worst election outcome with Theresa May’s Conservative party suffering a humiliating result. When calling the snap election just seven weeks ago, expectations were high that the Conservative party would increase their parliamentary majority significantly from the 650 seats available, to up to 400 seats from the 330 won in the 2015. Instead, May has fallen well short, and is on course to win 318 seats and a hung parliament, short of the 326 required for an absolute majority.
Theresa May called the election to give her a stronger hand in negotiating Brexit but is now battling for survival as leader of the opposition party Jeremy Corbyn has
called for her resignation, as well as perhaps calls from within her Conservative party. It is now not inconceivable that Jeremy Corbyn’s Labour party could form a coalition with the Scottish National Party and the Liberal Democrats to win the keys to Number 10 Downing Street. A more likely outcome, however, is that the Conservative party will form an alliance with Northern Ireland’s pro-Brexit Democratic Union Party (“DUP”) to inch closer to the 326 seats required. With 648 seats declared, the Conservatives have 317 seats, and the DUP 10. As expected, this political uncertainty has weakened sterling, and the reason that sterling hasn’t fallen further is that there must now be a higher risk that the UK does not follow through on Brexit. The election result will be deeply worrying to UK industry and those global businesses that are considering investing in the UK. A hung parliament leaves the UK in no man’s land of policy making with an extremely socialist Labour Party having moved closer to potentially leading a government.
WAKE UP WORLD, CHANGE IS THE NEW NORM
The UK electorate has delivered a real wake up call to the world. The vote represents the first emphatic effective vote by Millennials for a redistribution of wealth and power away from the old order. The UK establishment had written off Jeremy Corbyn the leader of the Labour Party as a dinosaur a character from a past, long gone era. Instead his brand of socialism has appeal to vast majority of millennials who seek a voice in what they believe to be an unjust world that fails to offer them a future. Educated, but left with debt, given a job but at a low wage and with very modest opportunity to advance in a career and left to rent with little prospect of owning their own home. Meanwhile they see over the horizon to a world where taxes can only rise to pay for an ageing population.
The Labour Party they have voted for offers them a protest vote of disruption to the normal political order – a commitment to a massive redistribution of wealth is at the core of Labour Party policies. That the numbers simply don’t add up in terms of what is promised doesn’t matter to the millennials one jot. Where Donald Trump has offered sound bites with little philosophy other than to just win an election Jeremy Corbyn offered a vision that was deeply unpopular with many but visionary for many of the young voters. Let there be no doubt that the UK election result should be another wake up call to the political elite that they must address the significant imbalances in the world or face an enormous popular backlash. As has often been the case in history unless the establishment brings those changes then the world could be facing change through the leadership of maverick individuals. Jeremy Corbyn may have laid down some laudable policies for a redistribution of wealth but his pacifist brand of foreign policy will be deeply disturbing to many in NATO and the United Nations. He has also proven to be a deeply divisive character even within his own party. Millennials don’t remember how socialism took the UK to the brink of bankruptcy in the 1970’s before a Margaret Thatcher led Conservative part righted the ship. Millennials face in their mind a dysfunctional world that struggles to offer them a positive inclusive future.
Although the result of the U.K. general election has so far been a surprise, it has failed to trigger the momentous market reactions witnessed post Brexit. US equity futures have moved marginally up, alongside Asian markets, gold has dropped for a third day and volatility measures are in general receding. This suggests that there is little potential for spillover effects of what is being perceived a local event.
The election outcome has significantly weakened the UK’s negotiating position in the Brexit discussions with the EU. With the complex talks on Britain’s departure from the EU due to start in just 10 days’ time, it is now unclear what the fundamental direction of Brexit will be. Indeed there must now be a doubt as to whether the UK ends up leaving the EU. Parliament had already
disagreed with the Brexit vote with the majority of MPs preferring to stay in the EU. The result of the election will embolden the anti-Brexit movement, but may mean a possible delay in the start of Brexit talks, and an increased risk that negotiations may fail. EU Budget Commissioner Guenther Oettinger told German broadcaster Deutschlandfunk, “With a weak negotiating partner, there’s a danger that the negotiations will turn out badly for both sides.”
FINANCIAL MARKETS REACT
An immediate reaction to the exit polls was a weakening in sterling, with cable falling 2.4% from 1.2950, and slightly recovering to 1.2730 at the time of writing, but far from the 1.20 that some commentators had warned of with a hung parliament. As we know, markets don’t like uncertainty. However, the FTSE has opened up nearly 50 points, as a weaker sterling boosts the income of overseas earnings – a major constituent of the FTSE 100.
UK EQUITIES – SUPPORTED BY DIVIDENDS
The FTSE 100 has had a stellar performance since the Brexit referendum trading at record highs and is +24% over the last year. Over the longer-term, performance will be dictated on how the Brexit process evolves, but we would put aside political uncertainty and focus on the composition of the FTSE 100 to ascertain where the Index is headed. The UK equity market is a defensive market with the highest dividend yield of 4.1% among the major markets, a positive in an environment of low bond yields. Eurozone equities yield 3.0%, the MSCI EM 2.6% and the US 2.0%. The performance of UK stocks has been inversely correlated to bond yields. On a yield gap metric the UK is the most attractive equity market compared to bonds. The performance of UK stocks is also inversely correlated to the movement in the pound as FTSE member companies generate about 70 per cent of their revenues overseas. The weakness in the pound since the Brexit vote, has sent the FTSE 100 to record highs. A lower GBP is a tailwind for exporters. A weaker currency in the short term, has the potential for renewed divergence between exporters and domestic UK
companies. Energy and material stocks make up 23% of the FTSE and have led to its outsize gains. The materials sector has been the best performer over the last one-year +56% followed by technology+ 39% and banks +28%. The large cap UK listed oil and commodity companies are global in nature rather than UK centric and should be viewed in light of the oil and commodity market fundamentals rather than the UK economic and political backdrop.
The FTSE100 is trading at 15.1x forward Price to earnings on expectations of a double digit earnings growth led by improved earnings from the oil, commodity and financials sector. This makes the market cheaper than other developed markets. In addition to the oil and commodity players a number of global consumer staple companies, listed in the UK pay dividends in excess of 3%.
UK GILTS – LITTLE CHANGE
We see limited strengthening of the UK Gilts which are currently at 1.06% and expect the steepening of the UK yield curve once further developments on the political front take shape. While sterling pressure remains, we could possibly see Gilts settle around the 1.00% handle in the near term on back of volatility. However, for the mid-to long term, steepening of the yield curve risks
cannot be ruled out. Any rally of safe-haven Gilts should be temporary in our view as rising concerns on the Brexit negotiations, and how policies unfold (with a Bank of England dovish stance) should keep bond markets range bound. Within the G7 bonds, UK Gilts emerge as expensive. While UK inflation has been above the target for a longer period, we could see higher Sovereign yields from the current levels leading to perhaps higher risk premium for corporate credits for the mid to longer term.
REAL ESTATE – MORE UNCERTAINTY
The uncertainty from this morning’s election result will have a divergent impact on the UK’s commercial and residential real estate markets. The key driver for the UK commercial property market since the ‘Brexit’ vote last year has been the weakness of GBP. This has made commercial property in the UK highly attractive to overseas buyers who are more concerned about preserving their capital over the long-term than short term pricing volatility and are principally driven by ‘push’ factors from their home markets (be it political, economic or real estate specific). The flood of overseas capital has supported the market to date, although listed real estate securities have traded sideways since the start of the year which indicates that, despite this, UK commercial property values will most likely remain flat for the remainder of 2017. We would support this view regardless of the current political turmoil. The UK housing market has been more affected by Brexit uncertainty than the commercial market and a hung parliament will only add further ambiguity. Despite supportive government policy, favourable supply/demand fundamentals, low financing costs and largely benign economic data, the UK residential market has been stagnant since the start of year. The latest data indicates that activity and prices have started to fall. The election result will certainly not lead to an improvement in sentiment so a short-term correction seems likely although there will be no severe price falls. In Central London, the luxury residential sector
continues to labour under a high tax burden in addition to the ongoing uncertainty. Unlike the rest of the UK housing market, the amended tax regime, not domestic politics, has been the key driver of the price corrections in prime London residential areas over the last 12- months. These tax changes are unlikely to be repealed in the medium term so further price falls are anticipated,
although there will come a time when overseas investors see value and re-enter the market, thus arresting any declines.
WHAT HAPPENS NEXT?
As the general election has resulted in a hung parliament, Theresa May remains Prime Minister for the time being, until it is decided who will form a new government, or she decides to resign. The
Conservatives will try and form the next government, most likely with the DUP. However, in a situation such as this, the party that came second is also able to form a government with the help of other parties. The Labour party, which finished second, may well look to form a minority government. There is likely to be a number of hurried talks as both parties aim to form a coalition government or a less formal deal. Negotiations are likely to run consecutively, with both holding talks with the same parties. There is no official time limit as to how long this may take. In 2010, it took five days for the coalition between the Conservatives and the Liberal Democrats to be formed. However, the new Parliament is due to meet on 13 June for the first time, and Theresa
May has until this time to put together a deal or to resign. If she is unlikely to, then Jeremy Corbyn and the Labour party will form a minority government. At the time writing, Theresa May is said to have reached an understanding with Northern Ireland’s DUP to form government, with cabinet minister announcements being made later in the day. We continue to live through a period of political turmoil, and voters are using their voice to keep the political classes in check, confounding the establishment. It shows that nothing can be taken for granted, and that in such periods, diversification of investments is absolutely necessary to reduce risks in an uncertain world.