THE FOLLOWING ARTICLE WAS WRITTEN AHEAD OF THE UK GENERAL ELECTION HELD ON 12TH DECEMBER 2019. TO READ RICHARD’S THOUGHTS ON THE IMPLICATIONS OF THE RESULT FOR THE UK ECONOMY AND MARKETS, CLICK HERE.
The world was in a dark place when Judy Garland burst onto the silver screen in glorious Technicolour on 25th August 1939, exactly a week before the outbreak of the conflict that would become known as World War II. The story – a re-telling of L. Frank Baum’s 1900 children’s novel, The Wonderful Wizard of Oz – has often been cited as an allegory for economic and political upheaval.
Eighty years on, and once again the geopolitical backdrop can certainly be described as fractious. The tension and its effect on social cohesion may well be unpleasant, but does not on its own suggest a doomsday scenario – in fact, far from it.
Brexit is just one piece of this complex jigsaw. For an event that was so often positioned at the time as having a binary outcome, the UK’s 2016 referendum on EU membership was, in reality, highly nuanced. As subsequent events have proved, rather than being a black or white decision, there was a veritable rainbow of possible outcomes.
As the count-down to year-end begins, and thoughts turn to the outlook for 2020, I believe that investors – like the lion who accompanied Dorothy to the Emerald City – would do well to have a greater degree of courage and conviction. To do so at this juncture, somewhat inevitably, means making certain assumptions based on the evidence available at the time of writing. Here, therefore, is my take on how things may play out.
Although the topic of Brexit may continue to divide political opinion in Britain for years to come, I believe investors can be optimistic that the logjam that has stymied the UK’s economic growth, and held back the stock market, is about to be broken.
The rationale behind my belief is that it feels increasingly likely that the forthcoming general election will result in a Conservative majority, and that the UK will withdraw from the EU at the end of January of next year on the basis of the revised deal negotiated by Boris Johnson. On the balance of probabilities, it looks similarly likely that the UK and the EU will then have a period of just 11 months to negotiate the details of their future trading relationship.
If my “base case” scenario for the election result ultimately transpires, I would expect sterling to strengthen further against the US dollar and the euro, by a minimum of 5%.
There remains a risk that some businesses may continue to defer investment and hiring decisions until much greater clarity is delivered on the nature of the future UK-EU economic relationship. Despite this, overall, I believe that the feeling of relief that would accompany tangible progress in the Brexit process should itself be sufficient to boost both business and consumer confidence.
Indeed, at the time of writing, there are numerous indications of an improving outlook for the UK’s manufacturing sector, which has been bumping along the bottom of a two-year downturn.
It is also worth reminding ourselves of the sheer scale of fiscal spending that both the Conservative and Labour parties have committed themselves to; whatever the outcome of the election, we can expect to see a dramatic rise in public sector expenditure, coupled with rises in the minimum wage which in turn should lead to a resumption in growth in real-terms wage increases.
It naturally follows that this, too, should be supportive for both consumer and business activity, which itself should translate into accelerating GDP growth. Against this backdrop, the Bank of England’s current forecasts look excessively gloomy, to my mind.
But even for those of us who devote a great proportion of our waking hours to thinking about the UK equity market, it is important to look beyond the UK’s shores for clues about the prospects for the economy and markets. In this respect, there is more to my optimistic outlook than expected progress with the Brexit process alone.
Policymakers globally are doing their bit to support global economic growth, from the US Federal Reserve’s decisions to ease monetary policy (not forgetting, also, its substantial actions in the Treasury market), to stimulus measures from the Bank of Japan and the European Central Bank, in addition to selected policy measures by China.
With the US facing a presidential election in 2020, we might also reasonably assume that Donald Trump’s attentions will soon turn decisively to winning a second term in the White House, with less focus on episodes of China-bashing. As the US election draws closer, it would seem increasingly plausible that some form of “phase one” trade agreement could be struck, even if a hypothetical “phase two” never actually materialises. For the foreseeable future though, these would be welcome developments for the global economy, and therefore for the UK, too.
Given these increasingly supportive economic fundamentals, the obvious question is, what would a Tory majority at the general election mean for UK equities?
On the one hand, it is worth pointing out that a strengthening in sterling would act as something of a brake on the earnings of big US dollar-earning multinationals like oil companies. Conversely, it would be a boon for many more domestically-oriented names.
That being said, my long-held view remains that the removal of the twin risks that have preyed on investors’ minds (a cliff-edge Brexit, and a Corbyn-led government) would trigger a re-rating of stocks that would more than compensate for any headwinds resulting from a stronger sterling. I believe it is just such a re-rating that would win back over those international investors who pulled out of the UK market in such large numbers in the aftermath of the referendum. This would be an overwhelming positive for UK equities.
An alternative view
In the interest of balance, let us consider an alternative scenario: Johnson loses his gamble in holding an early general election, and the UK finds itself with a Corbyn-led (possibly minority) Labour government, propped up by the SNP.
Corbyn then seeks to renegotiate the terms of the UK’s withdrawal from the EU, probably involving membership of the customs union, and acceptance of most EU regulations. This renegotiated deal is subsequently put to a referendum, with a choice between leaving on the terms of the new deal, or remaining a member of the EU.
I believe that the renewed uncertainty that would result from such an outcome would cause another material weakening in sterling, possibly of up to 10%, leading the UK’s US-dollar earning stocks to outperform, but placing renewed pressure on domestically focused businesses.
There is little doubting that large swings may occur in opinion polls between now and election day, but as it stands, the scenario I have just described seems highly unlikely to materialise. Put simply, the decision of Nigel Farage’s Brexit Party to stand down its candidates in Tory-held constituencies represents an acknowledgement that standing in all constituencies – and therefore dividing the pro-Brexit vote – would have increased the likelihood of a Corbyn-led government and, therefore, of no Brexit.
“We’re not in Kansas anymore”
To many observers, geopolitics has taken on an unfamiliar – even bewildering – hue in recent years. As investors though, part of our job is to assess observable facts, and to consider the probabilities of different sequences of events.
From where I stand, we are evidently not in Kansas – but neither are we in the Land of Oz, notwithstanding that the twists and turns of British politics have sometimes made it feel as though that might be the case. If I am right about the outcome of the general election, then I believe there is good cause for UK equity investors to be rather upbeat.