Investors and their advisers need to consider whether there is now a 'Brexit bubble' supporting the UK equity market, warns Guy Stephens, and position portfolios accordingly as future performance drivers shift
Elections always serve as a useful reminder of what democracy is supposed to represent. We are all aware that, in this age of populism, a significant proportion of the electorate is disillusioned with the western political system, which is encouraging support for more radical ideologies.
Although France has elected a pro-European moderate in Emmanuel Macron, who is ‘market-friendly', they have rejected the two mainstream incumbent parties. Imagine the same in the UK - it would be equivalent to the UK electorate rejecting the Conservatives and Labour and a new party of one year's tenure emerging victorious.
Some may recall the experience of Michael Foot in the 1983 election, the result of which was the Labour Party's lowest share of the vote. There has been a lot of commentary recently suggesting the Labour Party could be about to have a similar experience in this election.
And when you consider Jeremy Corbyn has already said he is not going anywhere, regardless of the election outcome, this implies he may be anticipating another leadership challenge very shortly … On the popular assumption the Conservatives do achieve a majority above 100, there is going to be internal turmoil within the Labour movement, especially if Corbyn continues to gain support from the unions. We will see.
It was precisely this kind of turmoil that led to the formation of the Social Democratic Party in 1981, shortly after the appointment of Michael Foot as leader, which pushed the party significantly to the left at the time. The disastrous showing at the 1983 election led to more defections and the subsequent alliance with the Liberal Party gave this centre-left party a real choice to offer the electorate.
Many years of centre-right rule then followed - including New Labour. This rise of a new electable alternative culminated in the Liberal Democrat coalition with David Cameron, which potentially led to both his downfall and that of the Liberal Democrats as two ideologies inevitably clashed, leading to unacceptable compromise on both sides.
If we consider the consensus the likely outcome for the current UK election, we need to think this through as far as the effect on markets. Both the UK equity market and the UK fixed interest market will be influenced but, more importantly the value of sterling.
If Theresa May is returned with a majority above 100, then we will have a Conservative Party that has lurched to the right with a lot of power and a very weak opposition, which will be in confusion and disarray. The current thought process is that this will provide a stronger hand when Brexit negotiations start and this should support sterling and be beneficial in terms of whatever deal is agreed.
Sterling's impact
As investors we must not forget the artificially positive impact sterling weakness has had on the performance of the FTSE 100 index, with its proportion of overseas earnings being around 75%. In addition, another performance driver of equity returns in portfolios has been overseas equity exposure where the FTSE World ex-UK index has risen by more than 30% in the last year in sterling terms.
So we have a situation where at least half a Medium Balanced portfolio with, say, 70% equity exposure for a UK investor, has been driven significantly higher by a one-off artificial currency movement, in combination with the Trump reflation trade.
When you consider that sterling is likely to have experienced most of its weakness for the foreseeable future and that most of the Trump reflation positives are priced in for now, the upside for equities from here is looking limited.
We have been telling clients the last year has seen exceptional returns and you should be careful not to forget that going forward, at some point, we will experience a correction and a negative year - though currently, we cannot foresee what will bring that about.
It is interesting to note, as we have been advocating, that the FTSE 250 had caught up with the FTSE 100 toward the end of April as value investors found opportunities within Brexit-sensitive sectors and as sterling recovered somewhat from its weakest point.
Since the French election, however, the euro has strengthened against sterling and Macron's pro-European stance has been perceived as reinforcing the EU negotiating position with the UK. The FTSE 100 has subsequently moved ahead once more and hit a new all-time high last week.
This means, just as the Brexit vote outcome had a profound effect on the performance of the UK equity market and overseas equity exposure as Sterling weakened, the future outcome of our Brexit negotiations and the subsequent effect on sterling will also have an abnormal influence on returns.
A contrarian view at the moment would be that Theresa May manages to strike a good deal for the UK, which is both pragmatic and acceptable to Brussels without affecting UK GDP. This may currently sound like a pipedream but at some point, after a significantly drawn out process, we will strike a deal that will enable businesses and the economy to adjust and adapt.
Whether this will translate into positive returns from the equity markets for a UK investor is difficult to determine but logic would suggest that, if sterling subsequently recovers, this will be a drag as the translation effect of overseas earnings reverses.
Condition yourself
On this basis, it would therefore appear sensible to examine the areas of strongest returns, ignore the warm glow of satisfaction that jumps off the page as you look at the profitable positions and condition yourself as if you were holding cash as to what to buy.
This will prevent behavioural bias from having an unhelpful influence that leads to investors continuing to hold investments because they have been profitable rather than considering taking that profit before it starts disappearing.
This is also the essence of value investing - and many can remember how careers were made and lost as the technology bubble burst from 2000 to 2003, when the unloved stocks began outperforming.
The real question is whether there is indeed a ‘Brexit bubble' supporting the UK equity market, driven by sterling weakness and apparent UK economic insensitivity. If there is and this starts to deflate for whatever reason we will need to position portfolios accordingly as the future performance drivers shift.
Guy Stephens is technical investment director at Rowan Dartington
