Out of the blue

The Conservative majority in the general election was the biggest surprise since John Major’s ‘soapbox’ victory in 1992.
As late as the day itself, it had appeared unlikely that any combination of parties would be able to form a coalition robust enough to last five years. A Conservative win was, to put it mildly, unexpected.

Insignificant moves

Although investors initially responded positively to the result, the moves were insignificant, apart from sterling, which rose 1.5 per cent against major currencies. However, while we understand the relief that a clear majority emerged, we believe there are some negative implications for investors from the Tory victory.

Last summer, with the Scottish independence referendum looming, our strategic asset allocation committee felt that political risks were increasing and reduced UK equities to a neutral weighting. Despite relief that we have avoided a weak coalition or a minority government, we have maintained this, mainly due to concerns about
the European Union (EU) referendum.

The election appeared to matter far less to financial markets than to the public. In the weeks beforehand, sterling was strong, particularly against non-dollar bloc countries; overseas holdings of gilts had one of their highest-ever monthly inflows in March and the FTSE 100 repeatedly broke through 7000, passing its previous all-time high. Not markets that one
would associate with political uncertainty.

Why were investors so sanguine? In spite of the increased media coverage, general elections are far less important to financial markets than they were 20 or 30 years ago. With 78 per cent of FTSE 100 revenues generated outside of the UK, and most significant legislation originating in Brussels rather than Westminster, the composition of the government has less scope to affect corporate earnings.

However, the principal reason for the indifference of investors was that, despite significant variations between the main parties in spending, the difference in the fiscal position by 2020 would have been negligible. The Institute of Fiscal Studies (IFS) analysed each party’s manifesto commitments and, although Labour would have been borrowing £30bn a year more by 2018/19, this would have been relatively immaterial in a global context.

This would have meant only a 5 per cent difference in public sector net debt to gross national income in 2020. The 77 per cent under Labour (against 72 per cent for the Tories) would still have left the UK with the second-lowest net debt to GDP in the G7, well below the US and France.

In spite of the rhetoric about austerity, there was actually little to choose between the two main parties in macroeconomic terms.

Black hole

What does the Conservative majority mean
for the UK economy? The IFS analysis revealed a £30bn hole in the Conservatives’ spending plans. Given their commitment not to raise income tax
or VAT in the next parliament, this will be met with spending cuts.

Given the pre-election populism that ring-fenced health, education, and other departments, these cuts are likely to fall mainly on the Ministries of Defence and Justice, and elements of the welfare budget.

More will become clear in the Budget on 8 July, but there will also be a full-blown spending review over the coming months. We have doubts about the plans to revive austerity in 2017 and 2018. Although the coalition talked up its record in implementing austerity after 2010, the truth is somewhat different.

Having started with bold intentions, the coalition diluted its plan in year two and had all
but abandoned austerity by 2014/15, no doubt influenced by its electoral prospects. The difference between the targets and the outcome was masked by better-than-expected GDP growth over the period.

While it is possible that a Conservative government, unfettered by coalition, will be more aggressive in reducing the size of the state, we think self-interest will prevail as 2020 approaches, particularly as David Cameron has committed to hand over to his successor by then. A new prime minister will surely eschew cuts in favour of pre-election popularity.

The outlook for interest rates is unaffected
by the election result. Although a majority government, and a Conservative one at that, is broadly positive for business confidence and growth, the impact of government spending cuts will offset this. With inflation around 0 per cent, interest rate rises remain some way off despite the health of the UK economy.

Although markets treated the parties as similar in macroeconomic terms, there were clearer differences in their microeconomic policies. Power generation and supply companies, and some banks, underperformed before the election as investors discounted a more interventionist approach from Labour. However, they may be disappointed if they believe the Conservatives will take a more laissez-faire approach to all sectors.

For example, there are serious problems with the UK power generation and supply sectors.
After years of government procrastination, we are at risk of serious supply problems in coming years.
The new administration will have to make some difficult decisions about how new capacity is built and paid for, while accepting that retail prices cannot rise ad infinitum.

Similarly, anyone expecting an easier ride for the banking sector may be disappointed. George Osborne seems as committed to the banks levy
as Labour, and has indicated that retail and investment banks may need to be broken up.
This is likely to help the new ‘challenger banks’, although they are difficult to invest in.

Public opinion

The biggest issue raised by the Tory majority is the EU referendum promised for 2017. As we saw with Scottish independence, referenda have a habit of getting out of control. Given the strength of public opinion against further EU integration, investors may fear that Cameron will struggle to keep the UK in Europe. Uncertainty could undermine foreign investment in the UK and this issue was highlighted as a key concern in Deloitte’s
recent CFO survey.

Given these risks, Cameron is likely to accelerate the process. He seems confident of reaching agreement with the EU about a different path for the UK and the referendum could be held in mid-2016. At this stage, it seems unlikely that the anti-EU camp will win as there is widespread political and business support for ongoing membership, but there will nonetheless be uncertainty in the run up to the referendum.

The Scottish National Party’s (SNP) success will raise the prospect of another referendum on Scottish independence. It seems likely that the SNP will campaign on this in the Scottish parliamentary elections next year, which could force the UK government into a rerun of last year’s referendum. Cameron will attempt to head this off with further devolution for Scotland and it is quite possible that he will avoid a second referendum before 2020.

A majority government was a welcome surprise, but it will have little impact on investors in the short term and we maintain a neutral weighting on the UK. Conservative governments are normally seen as good for business, but the spending cuts implied by the Tory manifesto and uncertainty ahead of the EU referendum will offset this.

Although better value than the US or Europe, UK equities are fairly valued and gilts look overvalued, although they will continue to be supported by demand displaced by quantitative easing in the eurozone. SJ

Jane Sydenham is an investment director at Rathbones Investment Management

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