The result of the election is very helpful for sterling and for UK equities, at least in the near term.
Small caps attractive
It should be especially beneficial, in our view, for UK small caps, which in general have become cheap relative to other indices, and could now rally. The Numis UK Smaller Companies Index (excluding Investment Trusts) was, immediately prior to the election, trading at around 12.1x forward price/earnings (P/E). This is cheap in historic terms, and the election result could be the catalyst for a rerating upwards. The election result should disproportionately benefit cheaply rated, UK consumer facing businesses that can rerate as uncertainty discounts unwind. Examples of such businesses are: Dart Group, the tour operator and airline; DFS, the sofa retailer; and OneSavings Bank, the mortgage lender and retail savings provider.
In our portfolios, we are well positioned to benefit from this scenario. Over the course of 2019, we have selectively reduced exposure to more expensive structural growth stocks, and have introduced holdings in well-run domestic cyclicals on low starting valuations.
Increased public expenditure is likely to be a theme of the new government. The Conservatives will need to pour resources into their newly won, ex-Labour northern constituencies if they wish to retain them when fighting the next election against a Labour Party under new leadership. Stocks exposed to spending on infrastructure could be beneficiaries. Examples include Speedy Hire, which rents out tools and equipment, and Breedon Group, the construction materials company.
A revival in IPOs
The IPO market in the UK will also benefit, we believe. Over the last few years, the number of IPO deals in the UK has fallen. In 2017 there were 81 IPOs, and in 2018 there were 68, but by the end of the third quarter of 2019 there had been only 19. After this election result, there could be an uptick in new issues fairly early in 2020, as issuers look to take advantage of improved sentiment and demand for UK equities.
However, looking further ahead, investors’ eyes will increasingly turn to what progress the new government makes on securing international trade deals. Any stalling of negotiations, with the EU or other trading partners, could weaken sterling – a key transmission mechanism between UK politics and the UK equities market. And if the market reaction in the wake of the Conservative win is overdone, it could fade once the nitty-gritty realities of getting a Brexit trade deal done become more apparent.
A potential further hurdle for the new government is a Scottish independence referendum. The scale of the SNP’s victory in Scotland may make pressure for an independence referendum irresistible.
The prime minister’s ability to overcome any such bumps in the road will be made easier by the large size of the Conservative majority in Westminster. This makes possible greater latitude for Boris Johnson to pursue a pragmatic trade deal that keeps the UK more aligned with existing arrangements.
The result of the election has introduced some much needed clarity. In the long term that is good for UK businesses and for UK equities.