Hazard warning

So could investors, blinded by growing optimism on the recovering UK economy, be underestimating political risk? Jeremy Tigue, manager of Foreign & Colonial Investment Trust, thinks this could indeed be the case. He points out the City tends to be “instinctively Conservative” with an assumption that the Conservatives will win the next election - something that Mr Tigue warns is “not a done deal.” He expects to see companies putting investment decisions on hold ahead of the election and, “more and more companies being caught in the political crosshairs.”

On the plus side, there could be a bit of a pre-election boost for the economy as the current government aims to create a feel-good factor going into the next general election. “UK elections next year will lead to an element of pump-priming to add to what are already relatively strong consensus growth forecasts,” says N+1 Singer head of research Mark Gibbon. Analysts at Credit Suisse concur. “We believe policy will remain highly stimulatory through 2014, with the government mindful that the next election is scheduled for May 2015.” They point out that better than expected UK economic growth has led to a windfall worth an estimated 1.2 per cent of GDP for the government, which is likely to find its way into higher spending commitments. There is still a big chunk of the Funding for Lending scheme to come through and the increase in the minimum wage should provide a boost.

One can also draw comfort from the fact that the stock market tends to take politics with a healthy pinch of salt. Consider the 2010 general election; a hung parliament, hastily drawn up coalition talks and predictions of resulting economic and political stalemate. While the FTSE 100 slid 7 per cent in the election month of May 2010, it had recovered its stride by the autumn and went on to deliver a 9 per gain over the year. Nevertheless any pre-election boost will be a temporary phenomenon and the political climate for business will change considerably if Labour wins the next election. Centrica and SSE have already seen a combined £5bn wiped off their market capitalisations since Mr Miliband’s pledge to freeze power prices at the Labour party conference last September. Banks have also been in the firing line with Mr Miliband outlining plans to cap market share and tax bankers’ bonuses. And there is also talk of a Labour government ban on troubled outsourcers G4S and Serco.

As one would expect, these policies, which have earned Mr Miliband the tag ‘Red Ed’ have not gone down too well with the business community. “Some of the rhetoric we’ve heard recently suggests that business is somehow the enemy – we are not, and this could not be further from the truth;” the CBI’s Sir Mike again. Energy companies have responded furiously to the power price freeze pledge, while critics of Labour’s banking reforms have included Bank of England Governor Mark Carney. Labour’s new direction has also set the City’s nerves jangling. When James Clunie, manager of Jupiter Asset Management's Absolute Return fund was asked at a recent media gathering how scared investors should be of Ed Miliband he replied: "Very scared - on a scale of one to 10; eight or nine.” The Labour pre-election juggernaut appears unlikely to respond to criticism by business leaders or the City and is likely to keep mining the rich seam of discontent over stalled real incomes and the rising cost of living. That means we may well see a ramping up of ‘Red Ed’ rhetoric as we head towards the general election. Certain sectors look likely to remain in the firing line as we outline in the following pages.

Banks innately political

Few sectors face quite as much political meddling as the banks. Indeed, given the huge taxpayer bailouts for the likes of RBS and Lloyds – to say nothing of the implicit state support made available for many other lenders through the provision of liquidity – it would be odd if politicians didn’t stick their noses into the sector.

One of the more costly politically-inspired measures to hit the banks since the financial crisis is the bank levy. This was introduced three years ago and was designed to raise around £2.5bn a year in total for the exchequer. The government justified the move on the basis that it’s right for the banks to pay something back after having received so much state support. “The country stood behind the banks in the crisis, and now it is right that they support the country in recovery,” said Chancellor George Osborne in December’s Autumn Statement. The problem is that the rate - which is applied to banks’ risk-weighted assets and has recently been expanded to cover foreign bank branches - keeps rising. In fact, it has increased six times, from 0.07 per cent to 0.156 per cent, because the amounts raised keep falling short of the government’s target.

Then there are the more politicised elements of regulatory reform to consider. For example, the report from the Independent Commission on Banking, chaired by Sir John Vickers, spoke at length for the need to create more competition within the banking sector. Moreover, EU competition regulators are forcing RBS and Lloyds to divest branches – 314 at the former and 632 at the latter - as the price for state support during the financial crisis. The Lloyds branches have been split into a separate TSB arm and will be probably floated later this year. While RBS’s branches have been branded as Williams & Glynn and sold to a Church of England-backed consortium. That competition theme has been taken up by Labour Leader Ed Miliband, too. In January he promised that the next Labour government would fix the UK’s “broken” banking market with an unspecified cap on the market share that a bank can hold. If that cap is breached, the bank in question would be broken up and branches sold.

While attacking banks may appeal to the bank-hating public, the reasoning behind Mr Miliband’s policy isn’t so easy to follow. To begin with, it’s really not so clear that the UK’s banking market is especially anti-competitive. The ECB reckons, for instance, that an average of five large players in EU states account for 60 per cent of the local market - in the UK, the figure is 41 per cent. So merely requiring competition regulators to set a market share cap, without exploring the extent of the competition problem to begin with, looks hard to justify. The idea hasn’t been well received in the City. “Just breaking up an institution doesn’t necessarily create a more intensive competitive structure,” reckons Bank of England Governor Mark Carney. While the BBA’s chief executive Anthony Browne points out that, “banks who are approaching their market cap would be stripped of incentives to invest and improve their services” – suggesting that Labour’s measures could even undermine competition.

Bankers’ bonuses are another hugely contentious issue that politicians just can’t leave alone. Given bankers’ behaviour on this issue, perhaps that’s not so surprising. Barclays, for instance, bulked up its bonus pot from 2012’s £2.2bn to £2.4bn in 2013, while largely state-owned lender RBS, paid out a hefty £576m in bonuses last year- despite having reported a thumping £8.2bn loss. After the financial crisis, the last Labour government introduced a tax on bankers’ bonuses, while the current government has capped the cash bonuses that are available at largely state-owned RBS to £2,000. Perversely, it’s feared that RBS could attempt to make use of EU regulations, designed to cap bonuses, to circumvent this – from 2015 bonuses will be capped at 200 per cent of basic salary, if shareholders approve. The EU ruling is being challenged by the UK government, although not because of RBS. It’s opposed to a blanket ban on the basis that it could force up basic pay and therefore affect banks’ financial stability. Enter the Labour Party again. Sensing the public mood, it called upon the government back in January to ensure that RBS can’t use EU rules to bolster bonuses and reckons that “it shouldn’t have taken the EU” to introduce a cap. While, just this month, shadow chancellor Ed Balls said that he’d introduce a second windfall tax on bankers’ bonuses - if the sector fails to show restraint - in order to fund job creation measures for young people. The party is already committed to raising £1.5bn-£2bn from a tax on bonuses during its first year in office. Mr Carney, meanwhile, has dismissed caps on bonuses as “crude”.

Finally, the re-privatisation process for Lloyds and RBS will, inevitably, be heavily influenced by political calculation. Admittedly, reprivatising RBS looks unlikely to get going anytime soon. Its shares still trade well below the government’s average 502p a share buy-in price – not being perceived to have lost taxpayers’ money is a key political priority – and Business Secretary Vince Cable reckons that reprivatisation inside five years is “unrealistic”. But it’s a different story at Lloyds. Reprivatisation there began in September after the government sold, through an institutional placing, a 6 per cent stake in Lloyds. It’s thought likely that it will push though a further disposal later this year, which may include a retail investor offering alongside a further placing. At the time of the initial disposal Ian Gordon, a banking analyst at Investec Securities, even felt that the government could be “out in full by the election” – a political, not a market-driven, timescale.

Utilities caught in the crosshairs

When Labour Leader Ed Miliband announced plans to freeze energy prices at his party conference in September, it was a defining moment for both politics and business. His proposal of a 20-month cap on power prices and reforms for the energy supply market generated mass media coverage and an angry backlash from energy companies. Mr Miliband’s target is obvious. Energy bills are a huge strain on squeezed households. Even within the Conservative Party ranks there is much discomfort on this issue with former Prime Minister John Major mooting a windfall tax on energy companies.

But the energy suppliers argue they are merely the middlemen, passing on rising costs whilst making only a slim profit margin for themselves. The CBI’s Sir Mike lends support to their argument: “overly simplistic statements regarding price controls or windfall taxes may play to public opinion, but they will not address the complex problems that need to be resolved.” British Gas likes to point out that taking the average gas and electricity bill of £1,253 for 2013, only £50 or 4 per cent was company profit. The rest of the bill is made up of wholesale energy costs, the costs of delivering energy and the costs of environmental and social policies. The current government has attempted to defuse the debate by moving the burden of environmental and social policies into general taxation, but that only slices around £50 off the average bill so the larger issue of how to protect consumers from the cost of ‘keeping the lights on’ remains a pressing one.

Wide of the mark or not, Mr Miliband’s proposal has created a cloud of uncertainty that will hang over the sector at least until the next election and well beyond that should a Labour-led government triumph. “We believe that Labour will continue its populist attacks on these companies,” says Whitman Howard utilities analyst Angelos Anastasiou. He goes on: “Extremely disappointingly, the continuing attacks have already increased the cost of capital in the industry, thus already adding to the long term costs for customers, rather than decreasing them.” The uncertainty has wreaked havoc with share prices. British gas owner Centrica and SSE have seen their shares tumble in the wake of Mr Miliband’s comments with little sign of investors wanting to bottom fish just yet.

Credit Suisse utilities analyst Mark Freshney does see some light amidst the gloom though. He believes that even if Labour were to win the next general election, its proposed energy price freeze would be “unworkable in practice,” with “major concessions” likely. He argues that a price freeze could pressure credit ratings and cause some of the smaller independent players to close. He also notes that the UK’s reserve margin - headroom of peak generation supply over peak demand - is only 4 to 7 per cent compared to 20 per cent or more in Continental Europe. The UK needs more investment in new generation but the investors in new generation are mostly the same as the ‘big six’ energy suppliers who would likely slow investment in the event of a price freeze.

Outsourcers under the microscope

The exposure of overcharging on UK government prisoner-tagging contracts at G4S and Serco last summer led to a Serious Fraud Office (SFO) investigation and the pair being barred from bidding for government work while a wider review of government contracts held by the two companies was undertaken. Both have now agreed a financial settlement with the UK government for the tagging contracts and Serco has been told it can now bid for central government work again - although G4S remains blacklisted as investigations are still ongoing. It is fair to say that the outcome probably matters much more to Serco, as almost 40 per cent of its revenues have historically come from UK government work against only around 9 per cent for G4S.

Most observers believe that the UK government is still keen to work with what are, after all, two of its biggest suppliers. “We do not think G4S or Serco will be frozen out; it would be wrong to sound the death knell of the public sector outsourcing industry,” says Cantor Fitzgerald support services analyst Caroline de la Soujeole. She points out that the government plans to cut the public sector deficit by 11 per cent by 2018/19, with around 80 per cent of that decrease coming from public sector spending cuts, and she notes that typically cost savings of 10-30 per cent can be achieved through outsourcing. Thus outsourcing remains a key part of the current government’s agenda. After all, civil servants are seemingly no less prone to making a mess of things than private companies, and they are also tend to be more expensive.

But even if Serco and G4S are allowed back to the bidding table, their problems may not be over. A climate of intense political scrutiny of their contracts is likely to prevail and the government may prefer to go with less controversial rivals where it can. The award of the recent Ministry of Defence strategic partnership for the Defence Infrastructure Organisation to Capita over rival bidder Serco could well be a case in point. Uncertainty over how a Labour government may treat the pair could also be an issue with press reports that Labour could even reverse contracts that had been awarded by the previous government. Sadiq Khan MP, Labour’s Shadow Justice Secretary, did not mince his words when responding to the news that G4S had agreed to repay the government for over-charging on tagging contracts. “It is not for G4S to feel it can just wipe the slate clean. The Serious Fraud Office is still investigating, and G4S should be treated in just the same way as any member of the public would, with no special cosy deals between the Tory-led Government and big business.”

Housebuilders: Your government needs you

There are two main routes for political interference in the housebuilding sector. Firstly, moves aimed at influencing housing supply and demand; and secondly, policies that target the development process. The coalition government’s Help to Buy scheme falls into the first category and has been a shot in the arm for the housing market. The initial phase of the scheme applied only to first-time buyers and new homes, but the scheme was extended in October to cover all buyers and existing homes allowing homebuyers to purchase a house with as little as a 5 per cent deposit with the government guaranteeing the remainder of the deposit. The government has earmarked £12bn worth of deposit guarantees, which would support £130bn of lending for low-deposit mortgages.

The scheme has already had a palpable impact on the housing market. According to data from the British Bankers' Association, mortgage approvals in December were up 42 per cent on-year, hitting their highest level for six years. Housebuilder Barratt meanwhile said that getting on for a third of all the new homes it completed in the second half of 2013 were bought on the help to buy scheme. There have been some concerns the scheme is working rather too well with worries that it could generate a housing market bubble. But as Gary Potter and Anthony Willis of fund manager F&C’s multi-manager team pointed out in their 2014 outlook, there is good reason to believe that government policy will remain supportive. “The government will be sure to support this housing recovery, given the positive halo effect, as it seeks a continued pickup heading into the 2015 election.” Economists at Credit Suisse meanwhile note that after the first month of the extended scheme, only around £365m of lending had been taken up, which implies that the scheme “retains significant firepower to support the housing market over the next three years.”

The second area of political influence comprises the development process. The pace of building new homes has been frustratingly slow with housebuilders blaming a cumbersome planning process. The coalition government has responded with an attack on planning red tape, which should be good news for the housebuilders as they say they make a better return from building on the land than leaving it sitting in their land bank. But Labour is taking a harder line, turning its fire on the housebuilders themselves. Fresh from his attack on the energy suppliers, Miliband took aim at the housebuilders saying his party would issue a “use the land or lose the land” ultimatum to housebuilders, with penalties for sitting on undeveloped land or even the forced sale of the land back to local councils. But the reality is that whoever wins the next election needs to tread carefully here given that alienating the very companies that build the new homes so badly needed could slow the development process even more.

Bookies not such a sure bet

UK bookmakers have had a torrid time of late amid mounting concerns over a clamp down on Fixed Odds Betting Terminals (FOBTs) - shares in Ladbrokes and William Hill are down 19 per cent and 10 per cent, respectively, in the past six months. Labour has made it clear that it would take a firm line with the sector were it to win the next election, tabling a motion to give local authorities powers that would allow them to place caps on FOBTs in early January. The motion was defeated, but the bookmakers are by no means out of the woods with David Cameron seemingly agreeing with Mr Miliband on this one; “I absolutely share concerns.” The coalition government is considering placing restrictions on the amount people can bet when they play the machines, which if implemented could be a major blow to the bookmakers and likely lead to some of their shops becoming unprofitable.

“There is a clear regulatory risk to FOBTs in the UK, and we expect this to continue to pressure the share prices for both stocks,” warned analysts at Credit Suisse in January who estimate that were the government to enforce a maximum FOBT game stake of £20, Ladbrokes could see a 20 per cent decline in earnings per share and William Hill a 9 per cent decline. However, they add that concerns look overdone following the recent share price falls, and they see upside risk for William Hill; “even if there were to be an extreme regulatory headwind (which we view as highly unlikely), we still see upside to the current share price.” The analysts note that the coalition government has said that it would only act on empirical evidence with a government-initiated study due to report back later this year. They add that recent studies suggest that problem gambling has declined recently, meaning the government-commissioned report will “not necessarily” find a link between gaming machines and problem gambling. And indeed, both companies have seen a bounce in their shares in the past month. Looking further out, though, the analysts at Credit Suisse do admit that the effect of a Labour election win would have on the bookmakers’ earnings is “less clear.”