By John Wyn-Evans, Head of Investment Strategy at Investec Wealth & Investment,
The reaction in financial markets is muted. From a global perspective we have to put this election into context. It really means very little for the rest of the world, which we have to bear in mind in the face of the face of shrill wall-to-wall domestic media coverage.
The biggest mover overnight, as we expected, is the pound. On a trade-weighted basis it has fallen less than 2%, leaving it at just below $1.27 and €1.135. However, relative to Brexit night this is a very limited fall, and to put the move into context, sterling is now almost exactly where it was before the election was announced. The pound is no longer deemed to be overvalued. The tail-risk of a Labour win, which might have been more negative, has been removed, at least for the time being. Furthermore, the prospect of a “hard” Brexit has possibly been reduced. Thanks to the pound’s fall, the FTSE 100 enjoyed a relatively strong opening, up just over 1%, although some of that gain has been given back. There is quite a sharp divergence in performance between overseas earners (up) and domestic cyclicals (down). There is also a nice bounce for the Utility shares that were under threat of renationalisation. In contrast the more UK-centric small and mid-cap indices are lower this morning.
The gilt market is also pretty unmoved by these events, with the 10-year yield effectively unchanged at 1.03%. There are several conflicting forces acting upon gilts. Government bonds’ safe haven status will tend to be supportive during times of uncertainty, but there is also a risk that the fragility of the government is a disincentive to hold them, particularly for overseas investors. The apparent vote against a “hard” Brexit and a second Scottish referendum is more supportive. However, the anti-austerity protest that also seems to be encapsulated in this result would suggest higher deficits and thus a greater supply of bonds, putting some upwards pressure on yields. Lack of political certainty and the threat of yet another election might also weigh on economic activity in general, particularly in terms of longer term investment. This would suggest a more benign environment for bonds. As long as the UK remains solvent, government bonds should continue to trade in line with global trends. There is no reason to expect the Bank of England to change its current monetary policy. In fact, the longer the uncertainty, the longer the status quo will persist.
So now what? This is where the speculation begins. Obviously, with Brexit negotiations due to start in 10 days, the government does not appear to be in a strong position. Moreover there are strong calls for the Prime Minister’s resignation, and not just from outside the party. This raises the biggest point of future uncertainty. Will she go? And if she does, will the party go for a hard or soft Brexit prime minister? Until this is resolved it is difficult to make further strong asset allocation decisions. However, ongoing uncertainty potentially leaves sterling under some pressure. It is certainly hard to see it rallying strongly.
The next big question is whether or not we have another election. That would again delay the Brexit negotiations, and potentially open the door further to the Labour Party who have the strongest momentum at the moment. There is though one technicality to consider, and that is an argument to try to hold on until October 2018, when constituency boundary changes take effect. These are estimated to bolster the Tory presence by a net 25-30 seats. So the Tories could try to hobble on until then.
We are not minded to make any changes to our risk position or tactical asset allocation today in light of what we currently know and the markets’ initial reaction.