Restore British Equities to an Overweight in the Wake of the Conservatives’ Electoral Victory

Investor euphoria in the aftermath of the astonishing Conservative (Tory) party triumph in the May 7th general election is underpinning equity market returns and has reversed some of the losses in UK sovereign debt (gilts) that accrued ahead of the ballot.  In defiance of pre-election opinion polls conducted before the nationwide vote earlier this month, the Tories secured a slim, six-seat parliamentary majority in the House of Commons at the expense of both their Labor and Liberal-Democratic opponents.

British Labor Productivity, Current Account and Real GDP Growth Trends

In the immediate run-up to the vote, the mood among investors had turned decidedly bearish since pre-election polls had been foretokening neither the Conservative nor the Labor party garnering the requisite 326 seats in the national legislature to rule alone.  Symptomatic of the progressively bearish tone in the domestic financial markets, both gilts and the FTSE 100 surrendered 2.9 and 3.1 percent denominated in sterling (GBP) and US dollar (USD) terms, respectively – as the pound lost 2.4 percent in nominal, effective trade-weighted terms.

Sterling/Euro Exchange Rate, FTSE 100 Price-Earnings Ratio* and UK Ten Year Sovereign Yield Trends

Contrary to the pre-election sell-off of UK shares, bonds and currency, investor reaction to the Tories’ surprise victory was comprehensively exhilarating immediately afterwards.  The FTSE 100 rallied 2.3 and 3.9 percent in GBP and USD terms, correspondingly; long-term gilts rebounded 1.1 percent and 2.7 percent in sterling and US dollars, in that order; and the pound recovered 1.8 percent on a nominal, effective trade-weighted basis.

Comparative British Sovereign Gilt Yield Curves

Since May 8th, however, investors’ expectations have resumed a much more realistic tone – especially, considering a second term-Tory regime under Prime Minister David Cameron has pledged to hold a national referendum on British membership in the European Union (EU).  Reflecting the resumption of pragmatism in market anticipations, long-dated UK government debt yields have recommenced their pre-election upward trend, mirrored by total return losses of 2.1 and 1.5 percent in GBP and USD terms, respectively, and denying the equity market of any discernible upside momentum, except in US dollar terms (1.3 percent).

In a series of upcoming high-level meetings, Premier Cameron will press Brussels to negotiate more favorable terms with regard to labor market flexibility and a host of other matters in exchange for Great Britain’s remaining in the EU.  Although the UK Independence party (UKIP) captured only one seat in the May 7th vote and Nigel Farage, who – as head of the UKIP – failed in his bid to win representation in parliament, Cameron is compelled to put the UK on a more competitive footing vis-à-vis its EU trading partners by negotiating new terms for maintaining its membership in the trade and customs bloc.  Brussels, though, is still reluctant to do so because if it were to renegotiate the terms of British membership in the EU to the satisfaction of London, it would encourage other members to demand preferential treatment – which could ultimately set in motion the dissolution of the EU.

What is at stake is Cameron’s credibility ahead of a much-anticipated showdown in the UK between internal political forces for and against Britain’s EU membership.  If he were to fail in his effort to get improved terms of British involvement in the trade and customs arrangement, he risks losing the plebiscite that he will probably reschedule from 2017 to 2016, ushering in period of significant uncertainty as Westminster prepares to enter protracted talks with Brussels on the UK’s withdrawal from the EU.  Yet, if London were to wrest better terms of its participation in the EU from Brussels, Cameron would likely avert an embarrassing defeat in the forthcoming referendum.  Gilt investors are expected to stay wary of any adverse developments ahead of the plebiscite.

British Consumer Inflation, Real Industrial Output and Inflation-Adjusted Retail Sales Trends

While a few key surmountable obstacles are obstructing Britain’s circumvention of a humiliating EU withdrawal, domestic economic performance should overshadow potentially damaging internal political hurdles and bolster investor confidence in the FTSE 100.  An unexpectedly weak, but transitory, 0.3 percent first-quarter real GDP rate of expansion, followed by a transition from inflation to deflation last month, will likely give way to 2.5 percent growth in real activity this year.  Induced by fractional lending rates stemming from an aggressively relaxed credit policy of the Bank of England, the domestic economic recovery will probably extend its reach to other regions of the country, broadening the rebound of business fixed investment and household consumption as a result.  A narrowing of fiscal and external shortfalls will also aid the British economy to the upside by underlining investor conviction in Britain’s creditworthiness, evident in Standard & Poor’s triple-A rating of its sovereign debt.

The reappointment of George Osborne to the cabinet post of Chancellor of the Exchequer by Prime Minister Cameron clearly signals that the direction of budgetary policy in London will not change anytime soon.  With Osborne remaining at the helm of the Exchequer, investors have been reassured of continued discipline in the management of the nation’s finances.  Moreover, Cameron also appointed Osborne as his deputy premier, or First Secretary of State, which implicitly anoints the Chancellor as the prime minister’s successor since Cameron has expressed his intentions of serving only two complete terms in office.  Further, the Chancellor’s fingerprints are conspicuously apparent in other prominent cabinet appointments, yet another sign Osborne is next in line to succeed Cameron and will adhere to the policies of improving UK’s competitiveness abroad.

The FTSE 100’s one-year forward, positive-adjusted price earnings multiple (p/e) of 16.8x is on par with Spain, more expensive than that of the French CAC’s and German DAX’s p/e ratios and cheaper than the multiples of their Danish, Dutch, Italian, Portuguese, Canadian, US, Japanese and Swiss rivals despite the fact that the FTSE 100’s p/e exceeds its twenty-two year historical average (16.0x).  On a relative valuation basis, FTSE 100 shares appear inexpensive by comparison with the S&P Europe 350 at -0.3.

Irrespective of the political impediments that lie ahead, Global Markets Intelligence (GMI) is convinced that if Premier Cameron succeeded in not just persuading a majority of Scottish electors to reject independence in last year’s plebiscite and getting voters to award his party with a majority of parliamentary seats, he is capable of performing another highly risky feat.  Achieving some compromise with Brussels to alter, no matter how modestly, the terms of the UK’s membership in the EU may dissuade Britons from casting their votes in support of removing Britain from Western Europe’s trade and customs bloc.  Macroeconomic and policymaking patterns in addition to propitious absolute and relative stock market valuations warrant our endorsement of an upgrade of the FTSE 100 to an overweight from its current market-weight exposure.

Subscribe to Insights