UK Election: Uncertainty Piled on Uncertainty

06/13/2017

Summary

The election was never going to put an end to the uncertainty facing the UK, given Brexit and the deteriorating economic picture. But the result piles uncertainty on uncertainty.

Key Takeaways

  • The UK election result may augur a more pragmatic approach to Brexit and increase the likelihood of a "soft" Brexit, perhaps even retaining access to the single market.
  • Our high-conviction view is that the Bank of England will put rate rises on hold for the next 2-3 years, or longer. The election reinforces such a view.
  • Speculation about another election puts downward pressure on sterling but economic data is likely to be the key driver.
  • A weak government or coalition probably means that fewer contentious manifesto pledges can be enacted – although there may still be action on utilities.

Initially billed as a tactical shoo-in for the UK Prime Minister, Theresa May's decision to call a snap election turned into a high-stakes gamble. One that failed to come off. Mrs. May called the election with the express aim of securing a stronger mandate – and bigger parliamentary majority – going into the Brexit talks that are due to begin on June 19 .

Instead, her Conservative party was left with insufficient seats to secure an overall majority. The result: a hung parliament.

In other words, a very different picture to the one anyone envisaged when Mrs. May emerged from No.10 Downing Street on April 18 to announce the election.

What went wrong for Mrs. May? She led a disastrous election campaign – compounded by opposition Labour leader Jeremy Corbyn's strong performance on the campaign trail, galvanising his core vote and attracting new, younger voters. He increased his party's share of the vote more than any other Labour leader in any election since 1945.

The Conservatives are likely to lead a relatively weak government through a deal with the Democratic Unionist Party in Northern Ireland.

Mrs. May's position is weakened and she may be replaced as leader of the Conservatives. Her credibility to negotiate Brexit is seriously undermined.

Investment implications

'Hard' vs. 'soft' Brexit, and the future of the wider United Kingdom
The exact Brexit implications are not immediately clear, although the result may augur a more realistic and pragmatic approach. Any deal will now have to be ratified by parliament, rather than simply waived through on a Conservative majority. But the process will be even more complex. The path of the Brexit negotiations will depend on the actions and views of the other 27 EU member states, and the two-year deadline for completing Brexit looks increasingly challenging.

The chances of a soft Brexit may have risen, which should be seen as positive. The dangers of a hard Brexit, with the UK failing to secure a trade deal – and having to rely on World Trade Organization rules instead – have diminished. Many hard Brexiteers preferred this route on day one, but it is fraught with uncertainties for almost all industries.

Elsewhere, the second Scottish independence referendum now seems very unlikely in the short term. The "Conservative and Unionist Party" fought a successful campaign focused solely on preventing a second independence referendum – the so-called IndyRef2. Labour also won back some seats from the SNP.

Sterling should remain fragile, although economic data will be the key driver
The British pound sterling was down more than 2 percent in the immediate aftermath of the vote. Markets had been trading on the dynamic that a larger majority would mean a better negotiating stance for Mrs. May and a softer Brexit. This was perhaps a false assumption, but in any event we now are in a new and unexpected environment.

Any possibility of another election – and uncertainty over who will lead the next government – puts downward pressure on sterling in the short term. Gilt yields are likely to rise somewhat.

Our high-conviction view is that the Bank of England will put rate rises on hold for the next 2-3 years, or longer – especially with gross domestic product growth falling back and household spending slowing as higher inflation bites. The election reinforces such a view, and this is ultimately negative for sterling. But we would need to see economic data continue to soften for sterling to weaken materially again.

Signs of a softer Brexit – and potentially a faster Brexit if the UK were to remain in the single market – would be good news for sterling.

Conservatives will set the agenda, and sector implications will be limited
Domestic stocks will be weak, but perhaps not too soft in the event that the Conservatives continue to lead the government. International earners (i.e., large parts of the FTSE 100) are likely to be stronger.

A weak government or coalition probably means that fewer contentious manifesto pledges can be enacted. Policies would face more parliamentary scrutiny, and this may mean proposals track more closely to the centre ground. And the uptick in voters aged 18 to 24 suggests that the younger generation are intent on making their voices heard in the democratic process.

There will be a risk of economic weakness from higher uncertainty. Higher bond yields may put a constraint on policy and spending, and investment into the UK could suffer from uncertainty –although, again, it will depend on how Brexit negotiations go.

Policy on reforms of corporate governance may take a back seat for a while, especially if May is no longer leader.

Looking at specific sector themes, price caps or other intervention on utilities may also be pushed back. But given that these fairness topics resonate with both main parties, we would expect some policy intervention on utilities.


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Macron Majority Gives His Reforms Momentum

06/19/2017
image: french flag

Summary

With a new majority in the French National Assembly, President Macron has increased the chances parliament will pass his ambitious reforms aimed at labor and economic growth. But France also faces some hard fiscal realities that may take some time to fix.

Key Takeaways

  • The results of the National Assembly elections are an important boost for President Macron as he seeks to advance his ambitious reform package.
  • Domestic French stocks are likely to benefit from Mr. Macron's economic reforms, including sectors such as construction, infrastructure and banks.
  • Despite the optimism, fixed-income investors shouldn't forget the fiscal realities that support a decent spread between France and Germany.

Ahead of France's presidential election in May, it seemed unlikely that the ultimate victor – whatever his or her political color – would go on to secure a majority in the National Assembly. The numbers seemed too finely balanced for that. But people had not fully factored in the meteoric rise of President Emmanuel Macron.

Mr. Macron has gained valuable leverage to push through his ambitious reform agenda

In the June 18 elections, Mr. Macron's La République En Marche (LREM) party – still only a year old – won a much sought-after parliamentary majority. This gives him valuable leverage to push through his ambitious reform agenda.

The result adds to Mr. Macron's power and legitimacy at home, while further enhancing his credibility abroad. It's likely that he will seek to pass the most difficult reforms – in particular, those related to labour law – as quickly as possible. French workers are, famously, among the most “expensive” in Europe. Mr. Macron wants to give employers more flexibility to negotiate deals with unions and employees on wages and hours, rather than having to stick to rigid rules. He is also looking at pension scheme reform.

The unemployment rate in France, at close to 10%, is higher than many neighbouring countries. During the presidential election campaign, Mr. Macron said a target of 7% by 2022 was "reasonable".

His other proposed measures include cutting the corporate tax rate from 33.3% to 25% and replacing France's wealth tax (ISF) with a tax on bricks-and-mortar real estate only – to encourage investment and entrepreneurialism.

Mr. Macron's proposed measures include cutting France’s corporate tax rate from 33.3% to 25%

Overall, his program is designed to address the country's structural weaknesses in terms of cost of work and competitiveness, and to attract foreign investors.

Investment implications

Boost for domestically exposed stocks
The most obvious short-term impact of Mr. Macron's reform package is on the re-rating of France. By moving quickly on parts of his reform agenda, Mr. Macron will send a positive signal that should buoy market perception. An important reason why the "Macron effect" has so far been muted for French equities is that the market does not have a lot of domestic exposure. Similar to the FTSE 100 in the UK, a majority of revenues are earned from international sales.

The more domestically exposed companies are likely to be the biggest beneficiaries of Mr. Macron's agenda. Sectors such as infrastructure, construction and banks should benefit from stronger growth and lower taxes – assuming he can push his reforms through.

French companies more domestically exposed are likely to be the biggest beneficiaries of Mr. Macron’s agenda

While not a Macron-specific story, defence sector stocks are also worth watching. In the wake of President Donald Trump's recent comments, European Union Commission President Jean-Claude Juncker reiterated the need for countries to stand on their own two feet when it comes to defence. This may translate into increased defence spending across the EU.

Optimistic fixed-income investors shouldn't forget the fiscal realities
Amid the optimism, fixed-income investors should keep in mind some of the hard fiscal realities. France may struggle to bring its budget deficit below 3% (as a percentage of gross domestic product) for 2017. The lingering lack of fiscal discipline – whatever the commitments for the subsequent years – should support a decent spread between France and Germany, despite the likelihood of a slight tightening between French and German government bonds in the immediate aftermath of these election results.

Political risk in Europe isn't going away anytime soon, but our near-term outlook for the region remains favorable
The UK election result is a reminder that the political landscape continues to throw up surprises. Perhaps the "elephant in the room" is Italy, which is facing continued political stagnation and an inability to pass much-needed reforms. There has been a great deal of speculation about a potential snap election being called for this autumn, instead of early 2018 as scheduled, but this is looking increasingly unlikely. The anti-establishment Five Star Movement seems to have derailed an electoral reform deal. This would have been a critical step in forcing early elections, which could have empowered Eurosceptic parties and posed a threat to the euro zone.

A strong 'Merkron' could put Europe back on a path toward achieving the job started in the 1950s: a truly United States of Europe

While political risk in Europe has not gone away, we continue to see a favourable near-term cyclical outlook for the euro zone. The election of Mr. Macron, the LREM's new parliamentary majority and the likely reaffirmation of Chancellor Angela Merkel in Germany should lead to a constructive partnership between France and Germany. A strong "Merkron" could put Europe back on a path toward achieving the job started in 1950s: a truly United States of Europe.

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