The country awoke this morning to news of a resounding, even historic, victory for the Conservative Party. Boris Johnson ran a low-risk campaign, uniting supporters behind a single, simple slogan: “Get Brexit Done”. In the end, Brexit has been the decisive factor, with the Tories winning seats in constituencies once sworn against them. In addition, the electorate appears to have rejected emphatically the policies on offer from Jeremy Corbyn’s Labour Party.
In years gone by, such a result might have been greeted with the sound of champagne corks popping in the City of London, but this time relief rather than rejoicing might be the order of the day. Yes, the worst case scenario of an aggressively socialist government has been avoided, but there is still much uncertainty about the financial sector’s future trading relationship with Europe.
Now the Prime Minister must not only focus on how Brexit is to be delivered, but also on restoring growth to an economy that has been hamstrung by three-and-a-half years of uncertainty. On the first point, we continue to judge the current Withdrawal Agreement as representing a very “hard” form of Brexit in which our trading relationship with the EU will be much less smooth than before. It will also not cover our strong service industries. Furthermore, we are unsure of the government’s ability to secure sufficiently attractive trade deals with other, more distant, countries to make up for any shortfall.
It would appear that Mr Johnson has sufficient numbers to get the bill through parliament, and for the UK officially to leave the EU on 31st January. However, it’s what happens after that which will be more interesting. There remains the not inconsiderable challenge of reaching a deal on our future trade relationship with the EU.
The deadline for that is currently set for 31st December 2020, and there is no shortage of voices claiming that there will be insufficient time to complete the necessary negotiations. That means that the threat of a “No Deal” Brexit is still live. However, there is already a strong body of opinion forming that Mr Johnson’s majority puts him in a position to be able to dictate his preference on the type of Brexit without being beholden to the extreme eurosceptic wing of the party. If that is the case, then both a “softer” Brexit, which will entail greater regulatory alignment with Europe, and an extension of the transition period are possible. This point was in fact conceded in the small hours by none other than Nigel Farage.
In terms of resuscitating growth, the geographic shift in support suggests, indeed demands, a greater focus on regional stimulus, especially if the Conservatives want to retain their mandate in the next election. It is also notable that many of the new Tory MPs are relatively young and not drawn from what one might consider the “traditional” pool of candidates, which supports a more inclusive style of government. Mr Johnson also referred to “One Nation” Conservatism in his victory speech, a phrase which he would not have used loosely.
The initial reaction from markets has been much as expected, with the pound rising to levels against the euro not seen since the immediate aftermath of the referendum, and against the dollar since early 2018. This reflects two things. First, any sort of Brexit resolution promises to unleash a wave of capital investment that has been supressed for a long time, boosting overall activity. This will be supported by the government’s manifesto spending plans. Second, the threat of a Labour government has been lifted. This was deemed to be hostile to business and also to raise the risk of meaningful capital flight from the UK.
Additionally, employees and consumers can look forward to a marginally more generous tax regime than they currently enjoy (and a lot more generous than would have been the case under Labour). However, sterling’s gains have been capped by the fact that Brexit remains unresolved. There is also the resurgent issue of a potential second referendum on Scottish independence to take into account, thanks to the SNP’s resounding success north of the border.
The result is thus a shot in the arm for domestically-focused companies, which are more concentrated in the mid and small-cap indices. Thus we expect them to continue to outperform relative to larger capitalisation companies as they regain some of their historic valuation premium, while also anticipating a stronger growth environment. The FTSE 100 Index will find itself constrained by its high overseas revenue exposure, as profits are translated back into sterling at a less advantageous rate. More positively, we are expecting to see international portfolio flows return to the UK as the risks are reduced. The shares of companies threatened by renationalisation have enjoyed a strong relief rally.
With an ever-growing share of portfolios now invested in international stocks, bonds and funds, the rise in the pound represents a real headwind to capital performance in the short term. However, this should be viewed in the context of potentially lower domestic inflation and increased buying power overseas. Indeed, because our central investment case is based upon a recovery in global economic activity in 2020, we are being presented with an opportunity to seek out good value in overseas markets at a better price.
Bond markets have, in contrast, sold off this morning, with the 10-year Gilt yield rising from 0.81% to 0.87%. The need for “safe haven” assets is now less compelling, and we can also look forward to an increase in government spending and therefore greater issuance of gilts. Even so, the upside for yields will be limited by the anchoring effect of low global interest rates and bond yields.
In a wider context, events here in the UK, however significant domestically, have a much lower impact globally. The fortunes of UK-based investors are ultimately more influenced by monetary policy around the world and by global growth trends. The US election in November 2020 will have far greater capacity to move global markets. It will be interesting to see what lessons the Democrats take from the fate of Jeremy Corbyn when selecting their candidate to oppose Donald Trump.
In the meantime, we will continue to stand by our core competence of allocating capital to where we identify the most attractive returns relative to the risk being assumed, and by investing in companies which have the potential to compound growth and returns for many years ahead.