Only a handful of general elections have taken place in December, and it’s curious to note that in 1923, the last time a December poll took place, the UK got its first Labour government, although Ramsay MacDonald relied on support from the Liberals. A similar scenario didn’t play out this time around, and even though we take a non-partisan approach to party politics, you get the feeling that retail investors might have dodged a bullet.
A Corbyn government was committed to an increase in the business tax rate, along with the introduction of a financial transactions tax, while your capital gains tax (CGT) allowance could have disappeared. Shareholders in utilities may have seen their holdings compulsorily acquired at prices determined by central government, doubtless triggering a widespread sell-off as the renationalisation process gathered pace. And then there was the little matter of forcing large companies to give each worker shares worth up to £500 a year. The effective expropriation of assets would not have instilled confidence in the UK equities market.
Little wonder that confirmation of a large – as opposed to simply ‘workable’ – Tory majority precipitated a step-up in valuations across the utilities and banking sectors, while consumer cyclical stocks also benefited from a post-electoral boost. The most noticeable share price reaction was attributable to the housebuilders, with the likes of Persimmon (PSN), Barratt Developments (BDEV) and Taylor Wimpey (TW.) all registering double-digit share price gains.
More drift on EU withdrawal despite mandate
However, the election may have only marked the end of the beginning. Even though investors won’t have to tailor their portfolios to take account of Marxist-Leninist dogma, they might have a little longer to wait before Boris Johnson makes good on his election pledge to ‘get Brexit done’.
Under the terms of the free trade negotiations with the European Union (EU), the transition period will last until 31 December 2020, but it’s unlikely that any comprehensive trade deal with the EU will be brokered prior to this date, during which time the UK will be forced to comply with existing EU rules and regulations.
An extended round of Brexit negotiations could conceivably take us through to the end of 2022. Investors could be left with little more than speculation on key trading policies with the EU. These could range from equivalence frameworks for UK financial services to the regulatory regime governing the pharmaceutical industry – the list goes on.
The UK does have one card up its sleeve in the coming negotiations. Our future trading arrangements with the EU may yet be shaped by the outcome of talks over the EU’s Multiannual Financial Framework for the period 2021/27.
The UK is the second largest net contributor to the EU budget. A looming fiscal shortfall comes at a time when the economy of the EU’s principal cash cow, Germany, is feeling the strain. So, it is just possible that Berlin might insist on a speedy resolution if a mutually beneficial arrangement can be found.
Unfortunately, fiscal profligacy isn’t confined to Brussels. Both major parties made significant spending pledges as part of their election campaigns, which would feed into increased short- to medium-term aggregate demand within the economy – the long-term effects are potentially more problematic.
Mid-tier valuations warrant attention
The construction sector is poised to get a shot in the arm through the Conservative party’s pledge to deliver a million more homes over the next five years, underpinned by further measures to facilitate home ownership. Manifesto pledges are made to be broken, but you’re left with the impression that this single issue has real political cache.
Equity valuations are moved by factors beyond the realm of politics, even quaint old assumptions linked to corporate fundamentals. But it would be unwise to downplay the impact of our epic dithering on the European issue, a reality borne out by recent index movements.
The market had been pricing in a Tory majority through November, evidenced by the outperformance of the domestically focused FTSE 250 against the UK benchmark. Brexit has had a greater negative impact on the UK’s mid-tier index, but it’s worth remembering that it has outperformed the FTSE 100 on a total-return basis since the turn of the millennium. And sterling’s gradual retracement has undermined the effective yield for UK investors from FTSE 100 constituents whose payouts are dollar denominated.
It is reasonable to assume that UK valuations have lost ground due to the political impasse – to what degree is another matter. Schroders estimates that UK equities are trading at a 30 per cent discount to global peers.
But does the relative decline make the UK benchmark index any less vulnerable to a correction in global equities markets? While it is true that UK valuations have failed to match those of other indices, it does not automatically follow that any prolonged sell-off would be less severe due to the simplistic assumption that other markets have further to fall.
The most heavily weighted stocks trading on the London Stock Exchange are global in nature, so their level of support hasn’t altered as dramatically as those further down the food chain.
Private equity remains a major influence
What’s interesting is that while UK investors have been light on domestic equities, institutional investors from abroad have been engaged in a feeding frenzy. The UK has recorded a substantial increase in its net investment deficit last year, as US investors piled in to increase their interests in undervalued UK assets.
Part of this is down to sterling weakness, so it is possible that support from abroad could dissipate, assuming the pound retraces in the post-electoral period, although anecdotal evidence suggests that private equity firms are poised to ramp up their ‘buy and build’ activities once the Brexit stalemate is broken. The second half of the year has seen approaches for defence contractor Cobham (COB) and theme park operator Merlin Entertainments (MERL), along with several other high-profile offers.
Dealmakers may be cautious, but they know a bargain when they see one. Indeed, private equity inflows have had an outsized influence on UK markets in recent times, although it is a point of conjecture as to whether their influence is wholly positive.
Funding options from private equity have undermined the London IPO market, demonstrable in their backing of the domestic fintech industry, the growth of which is not represented in UK indices – it remains largely a private affair.
Cheap credit and a possible reversion to value investing
Brexit anxieties have presumably played a part in the admissions slump. However, we don’t buy into the notion that the dam is about to burst if uncertainty eases, certainly not regarding small-caps or companies moving on to London’s junior market. The chief determinant remains the interest rate environment; if you’re not looking to establish a secondary market in your shares, there is little incentive to tap public markets when debt finance is relatively cheap.
Over time, a dearth of IPOs can have a negative effect on mid-tier index values which rely to a certain extent on the dynamism of their constituent lists, although the step up in M&A activity has helped on this score.
A lower-for-longer outlook on interest rates, combined with a decade of loose monetary policy has stretched valuations in certain corners of the market, hence the relative outperformance of growth stocks versus value plays, which is anomalous from a historical perspective. Chris Dillow recently pointed out that “the tech crash taught us that growth stocks can be systematically massively overpriced”. Although this doesn’t imply that value stocks are undervalued in absolute terms, if you take the view that the concept of fair value has taken a back seat, you would imagine the market could be awash with mispriced assets.
Quantitative easing (QE) programmes have distorted asset prices, but the pivot towards growth stocks could reflect the fact that valuation techniques have failed to take adequate account of the impact of intangible assets on corporate balance sheets. It may simply have become more difficult to identify potential value plays (areas such as intellectual property, customer data, IT and software are now the chief drivers of shareholder value, but intangibles now account for most of the potential dangers from a risk management perspective).
There are those who believe that QE has reached the limits of its effectiveness, so Boris Johnson’s government may be more inclined to go down the Keynesian route to stimulate growth in the economy. It’s a sobering thought given our national debt already represents 86 per cent of gross domestic product.
Nevertheless, the prime minister, if he is good to his word, may be gearing up to follow the lead of his US counterpart, by driving economic growth through infrastructure renewal. The theory runs that it is worth developing capital assets, which underpin wealth creation, when borrowing costs are low. This should drive profitability within the construction industry, particularly if he opts to initiate previously touted legacy projects.
Healthcare contractors will be delighted to learn that Tory plans to increase NHS spending by £33.9bn by 2023-24 will end up on the statute book. It’s a politically astute move given the spending commitment will be legally binding, but it should also improve top-line visibility for existing NHS contractors.
The surge in market indices following the election was capped by a rise in the value of sterling and its impact on FTSE 100 constituent valuations, although the removal of political uncertainty should precipitate increased inward investment across the board.
Overall, however, you would probably be well advised to increase your exposure to mid-tier stocks; this end of the market remains oversold relative to the UK benchmark from an historical perspective. It is certainly conceivable that the withdrawal of support for domestically oriented stocks was behind the step-up in M&A activity, implying that a value-focused approach might be the way forward in 2020.
