Calm or cool Britannia?

Opinion polls are pointing to a generational shift in the UK’s political landscape. Markets don’t have much to go on regarding Labour’s economic policies but are likely to take the view that a change from the policy chaos of recent years is welcome. The UK equity market could benefit. It is cheap and under-owned. Yet analysts are positive on earnings growth and interest rate cuts will help sentiment. Equities are cheap, sterling is cheap, and the UK represents a small share of global equity ownership. Boris Johnson and the lettuce-beaten Liz Truss have gone, Brexit has peaked, and policy priorities will shift away from small boats and Rwanda to climate and energy policy, investment and more flexible trade with Europe. Change should be good.

Change – Today is very different to 1997. Back then, the last time Labour won a UK general election, there had been no Gulf War or financial crisis. The group Oasis was still cool. Social media did not exist (think about that for a moment!) and web browsing had to be done through portals like America Online (later AOL) or Netscape. Yet there is a huge commonality regarding the UK political scene – the demand for change. In 1997, the Conservative government had been in power for 18 years. This time, the Conservatives have been in power for 14. Democracy allows for change when the electorate gets fed up with the incumbent government. Let someone else mess things up is the zeitgeist. The opinion polls suggest that a huge change will result from the 4 July vote. A recent YouGov poll suggests Labour will get 46% of the vote with the Conservatives receiving only 21%, translating to a 194-seat majority for Sir Keir Starmer’s Labour party. That would be a victory of historic proportions and change the political landscape in the UK for a generation.

Death spiral – Labour’s polling share over the last year has been between 40% and 50% with the Tories polling between 20% and 30%. Polls can be misleading, but it would be very surprising if they were so wrong that the election result was a complete surprise. Nigel Farage’s entry into the election campaign as Reform UK leader is further bad news for the Conservatives. Reform is unlikely to win any seats beyond where Farage is standing but it could take votes away from the Conservatives with some voters frustrated over issues like immigration. In marginal Conservative-held seats, this could create enough of an impact to deliver victory for Labour or one of the other parties. It is not inconceivable that the Conservative party will be left with a historically low number of seats and an existential split between traditional ‘One Nation’ conservatives and those enticed by the populism of Farage’s Reform agenda.

No fiscal shocks – The assumption of a Labour government is therefore likely to be a valid one. Yet, what to expect on the policy front is not clear. In the televised debate with Rishi Sunak on 4 June, Starmer ruled out increases to income tax and value-added tax (VAT) rates. He also suggested that any spending on public services or investment would have to be properly costed and funded. There is clearly a desire to send a message that his Labour government will not comply with the typical stereotype of ‘tax-and-spend.’ Some taxes will increase – on non-domestic residents, additional taxes on oil and gas companies, and removing VAT exemptions on private schools – but these are small fry in terms of the big fiscal picture. Labour is not shy in bringing up the Conservatives’ fiscal record – an increased overall tax burden and the fiscal disaster of the September 2022 Mini-Budget. The strategy is to put clear water between its promise of fiscal stability and the record of the Conservative government in recent years.

For the rates outlook in the UK, what the Bank of England (BoE) will do is more important than the election. Looking further ahead, however, any new government will have to start to deal with long-term fiscal weakness that results from ever-increasing financing needs for the National Health Service, poor demographics and an increase in sickness and disability credit recipients. You will not hear much about that before 4 July though.

Cool boring – I think there might be a softer, more sentiment-driven impact on how investors see the UK though. The political and policy chaos of recent years will be put to bed by the election. A new government is no guarantee of stability, but Keir Starmer gives something of an aura of being boring – which might not be a bad thing, especially considering what the Labour Party looked like in 2020 when Jeremy Corbyn led a much more left-wing party. Boring could be positive if it means policy stability and new policies being brought in that are not driven by populism. Companies will prefer such an environment.

More clarity for business – Areas where more clarity will be helpful include climate, energy and policy towards Europe. A committed net-zero strategy could be the catalyst for increased green investment by UK companies in areas like housebuilding, transportation and energy generation. Support for renewables should eventually lead to greater energy security and lower costs. A renegotiation of some of the terms of the relationship with the European Union (EU) would be welcome news for small and medium-sized companies that have had to deal with increased red tape in recent years. If Labour is also able to do a better job of managing immigration, then it may be beneficial both in terms of labour supply and managing pressure on housing, health and the education system.

UK equities – Much remains to be seen. For UK equities, however, there is the potential for some upgrade in investors’ minds should a more stable policy environment emerge. The mid-cap FTSE 250 equity index captures the bulk of UK domestically-focused companies. Historically, this index has delivered better returns than the large-cap FTSE 100 (dominated by companies with earnings derived from outside of the UK) with a 25-year annualised total return of 8.3% versus 4.8%. Of course, volatility has been higher, but the risk-adjusted return has been attractive over the long term. Since Brexit, the index has underperformed. In the last three years, to the end of May, the mid-cap index has had a total return of close to zero compared to 9.7% for the FTSE 100.

Cheap – This underperformance means that valuations have improved. The mid-cap index currently has a 12-month forward price-to-earnings ratio of 11.7 times, slightly below its three-year average. Most other equity indices have seen increased multiples in recent years. On the positive side, analysts have pencilled in strong earnings growth with the 12-month consensus forecast currently at nearly 20%, compared to 5% for the FTSE 100. Indeed, this is starting to be reflected in performance. In the three months to the close of 4 June, all the major UK equity markets were up around 9% in total return terms. Within the mid-cap index there is a lot of dispersion of performance too, which lends itself to active equity management. Year-to-date the best performing stock is up 167% while the worst has a negative total return of -50%. The median stock return so far this year is 6.2%.

At the global level, UK equities punch below their weight. As of September 2023, the share of the UK in the FTSE All-World Index was just 4%, compared to 61% for the US. It is likely less than that now given the huge increase in the market capitalisation of the US market. A half-percent reallocation of global equity funds to the UK would be worth over 20% of the value of the FTSE All-Share index. Such a move is probably pie in the sky, but there is an argument that things should align to generate a more positive view of the UK among global investors than has been the case since the country voted to leave the EU.

Things can only get better – We do expect the BoE to cut rates soon, probably in August and then again later in the year. May’s inflation report should show a large drop in headline rates and market expectations should reflect growing signs of a turn in the global rate cycle (with Bank of Canada and European Central Bank cuts this week and more confidence in the Federal Reserve easing). Lower rates, a change of government and England winning the Euros – a cool Britannia summer once again!

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(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 5 June 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.

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?Viewpoint CIO | AXA IM Corporate (axa-im.com)

Chris Iggo | AXA IM Corporate (axa-im.com) ?

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