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21/04/2017

CIO Blog: May in June

UK Snap Election Announcement

Just when one thought the UK’s exit preliminaries from the EU had concluded, Prime Minister Theresa May stunned markets by announcing a snap election on 8 June, the first since the Edward Heath’s government did so in 1974. The immediate market reaction was panic – Sterling sold off aggressively on the news – as investors digested yet another crashing wave of uncertainty in the ocean of the uncharted. However, once the initial hysterics wore off, not only did Sterling recover, but it added about 2.5% of gains. On the other hand, the FTSE 100 was sucker punched – closing down 2.5% – weighed by the surging pound, which reduces international profits for its large, global constituents. And that was day one. There is little doubt jittery markets are highly reactive these days, and will likely continue to be over the course of this election.

More importantly, the election does little to alter the consensus that negotiations will eventually result in no winners. Property prices in prime London are sharply lower, 30% by some estimates. All major banks are charting contingency plans to relocate at least some key staff from London to Europe. In spite of the snap election announcement linked rise, the pound is still languishing in its post-Brexit trough of between $1.20 and $1.30. Perhaps most troublingly, recent economic data shows Brexit beginning to bite, notably in rising inflation and eroding wage growth: a troubling portent.

However, we tend to view any overwhelmingly one-sided market position as a contrarian opportunity. Indeed, the last seven years have seen many of these:  "Taper Tantrum"; "Grexit"; the “Fiscal Cliff"; the election US President Donald Trump. In hindsight, each of those periods resulted in deeply oversold sentiment. Prudent investors eschewed the noise, remained focused on the fundamentals of valuation and momentum, and harvested the subsequent returns. The Brexit referendum provides perhaps the most apt example: in the trading days that followed the vote (June 24 and 27), the FTSE 100 fell by 5.7%. The urge to sell and take cover was strong. But in the four days that followed, it rebounded by 10%. From that post-Brexit low to post-snap election announcement, the FTSE 100 rose by 20%. The point is simple: a single day – or event such as this election – should not matter to long-term investors; keeping focused on valuation, momentum and sentiment should.

In a world focusing on what can go wrong with “Brexit”, we discuss what the market may be overlooking.

May be all for the best

First, once the initial shock wore off, it was obvious why the

the Prime Minster called the election: she thinks she can win without breaking a sweat! At present, polling suggests the Conservative Party has an 18% lead over Labour, its closest rival. Furthermore, Ms. May can win her own mandate – rather than piggybacking on the ex-PMs – while simultaneously tightening her grip on the party prior to the EU negotiations. To boot, it also extends Tory rule by two years to 2022. All of this puts the UK in a more advantageous position.

Second, the UK has a “goods deficit” and “services surplus” with the EU. Principal amongst these are financial services: the City provides 75% of foreign exchange trading and hedging products for the EU, and supports half of all lending. Moreover, the UK exports £26 billion of financial services to the EU, and imports just £3 billion. The UK has built an inimitable comparative advantage in these services; a sharp break in liquidity and capacity support could be detrimental to financial stability in the EU. On the other hand, the UK’s “goods deficit” with the EU – including items such as cars and wine – is one where alternative suppliers are relatively easier to find. The UK is likely to have more leverage than many believe.

Third is regulation. The EU has labyrinthine rules applying to nearly every aspect of life. This extends from toasters to taxation. Furthermore, no meaningful and substantive legislation can take place until it has approval from all member states. The absurdity of this arrangement was highlighted last year when Belgium could not sign a key trade deal with Canada because of objections from its Wallonia region. Wallonia, an area of just 3.6 million people, held up an agreement approved by the EU's 27 other governments, representing about 500 million people. Some believe that far from being a headwind, the UK will find it easier to trade with the rest of the world outside of the torturous strictures of EU process and consensus-building.

Fourth is an improving fiscal position. The UK’s net contribution to the EU is about £9 billion a year. This is a substantial, representing about 0.5% of GDP. It adds up to £45 billion over five years. Put this number into context. The Hinkley Point nuclear power plant will cost about £18 billion; a new runway at Heathrow runs at about £18 billion. Both are game changing pieces of infrastructure for the UK, and the savings for the UK could pay for both in just five years. 

Investment implications

The points set out in this piece are not predictions, nor are they political views. They are merely scenarios that represent factors which are difficult to see in the cacophony resulting in the aftermath of the referendum and the new theatrics linked to the snap election. To many, this furore demands a call to action, stimulating a primal instinct to react. We will do no such thing. As we noted in the run-up to the Brexit, the invocation of Article 50 – and myriad other geopolitical risk events – our investment process seeks to evaluate long term fundamentals rather than focus on short term movements. It is deliberately so. It aims to eschew the “noise” which inevitably surrounds such events, and looks at what we consider indelible, longstanding drivers of asset returns: valuation, momentum and sentiment. To the degree that geopolitical events impact the fundamentals, we pay attention. To the degree they do not, we remain positioned to take advantage of any excessively bearish sentiment by taking contrarian positions.

As markets digest and process new information – such as the snap election announcement – there may be elevated levels of noise for some time. Markets may move up or down sharply. They may settle, only to begin moving again. These events, in isolation, are not of concern to long-term investors: markets are replete with bouts of volatility. Prudent investors eschewed the noise, remained focused on the fundamentals of valuation and momentum, and harvested the subsequent returns.

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