Weekly Digest – Week ending 11 June 2017

Weekly Digest
Week ending 11 June 2017

Hung, Drawn and Quartered: The Demise of Strength and Stability
When PM Theresa May called the general election 7 weeks ago, ostensibly to deliver strong and stable leadership through the impending Brexit negotiations, the Conservative party enjoyed a commanding lead in the opinion polls which would have delivered a landslide victory. Despite a wholly inept campaign by May and a surprisingly good one by opposition leader Jeremy Corbyn, all expectations the day before the poll still called for a Tory win by a margin of 40-80 seats. So the result, a hung parliament with no single party having an overall majority, was a shock and is undoubtedly bad for the country, disastrous for the Conservative party and catastrophic for Mrs May. Here we provide our initial thoughts on what it means both shorter and longer term.

What does it mean for government policy?
The government will struggle to stick to its austerity programme and tight spending policy. One message from the electorate appears to be that more spending on health, education, policing, security, infrastructure and social care is vital and if the Tories are to win in 2022 they will have to loosen the purse strings. More spending, tax rises and higher debt seem inevitable.

What about Brexit?
Brexit negotiations are due to start in seven days. It is possible that the government will not be in a position to do so; negotiations to form a government with the DUP could take some time, as would a leadership election (which could be hard to avoid). A mortally wounded PM is arguably not best placed to lead these critical negotiations, and some delay seems possible. This plays into the hands of the EU and weakens the UK’s position as the two year exit period is ticking down. Furthermore, the election result is likely to be interpreted as a rejection of May’s negotiating position, which is widely seen as a hard Brexit with the UK exiting the single market and customs union in order to regain control of immigration from the EU and independence from the European Court of Justice.

How does this affect the UK in the longer term?
Hung parliaments and coalition governments with a very slim majority are fraught with risk and given the multitude of evident divisions in the UK, between the haves and have-nots, young and old, Brexiteers and Remainers, those who have benefitted from the forces of globalisation and those who have suffered, all point to huge challenges for the government to survive. However, the DUP are likely to be reliable partners, albeit at some cost, so the prospects of surviving a full 5 year term are reasonable. The bigger problems come from the Brexit negotiations and the ultimate exit arrangements, and the growing prospect of a hard left government in five years. The Labour party under Corbyn, with his entrenched extreme left, anti-business, pro big government and state intervention, high tax and spend philosophy (and manifesto), has now been given the golden opportunity to build a significant base in parliament and will be more than ready in five years to take advantage of policy mis-steps by the government, and any post Brexit economic malaise, to form a government. This is hardly likely to be an investor-friendly environment and could well end in stagflation, high debt and weak capital markets.

What should investors do?
The result was a shock for markets but so far they have reacted predictably and calmly: sterling and gilts have weakened somewhat, internationally focused UK equities have strengthened while domestic oriented equities have weakened modestly. This seems appropriate. Markets dislike uncertainty but it should be remembered that although the result was a shock the government has not changed and is unlikely to do so, quite possibly for the full five year term. The socialist Labour party did not win and cannot form a government, so the worst outcome for markets has been avoided. We face a period of uncertainty, greater than we had hoped and expected prior to the election, and government policy both domestically and in terms of Brexit has to be revisited; very significant changes are inevitable but the broad thrust of Tory philosophy is intact. The end result could even be a more pro-growth policy mix, with an increase in government spending, and a softer Brexit, which would resonate well with investors.

Under these circumstances we believe that the best course of action is to sit out the immediate heightened uncertainty and take stock as the new government and its policies become clearer. It is important to stress that this is purely a UK domestic issue and has no bearing on global markets. The UK market has performed well since the sharp falls immediately after last year’s referendum and we have been anticipating a period of consolidation and drift in equities in the shorter term. Our portfolios are already positioned for this. Should there be unexpected shocks and weakness in markets in the UK, our current thinking is to use these as buying opportunities, but the moves so far are insufficient. Sterling is an undervalued currency but as with Brexit, the uncertainty created by the election is most likely to fall on the currency, so further weakness cannot be ruled out in the shorter term. Patience and calm seem the best approach in this environment.

The Marketplace

  • Conservatives fall short of majority in UK election
  • ECB revises core inflation and growth forecasts
  • Limited market response to Comey testimony
  • Strong US economic data reaffirms rate hike expectations
  • US responds to Qatar and Gulf diplomatic crisis

Market Focus

UK

USA

Europe

Courtesy of Momentum Harmony Funds
Source: Bloomberg. Returns in local currency unless otherwise stated.

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