Hung Parliament may not hamstring FTSE 100

... (although oil, the dollar, metals prices and interest rates still could)

A dreadfully poor campaign, where the slogan “Strong and Stable Government” smacked far too much of Tory Prime Minister Stanley Baldwin’s uninspiring and unsuccessful “Safety First” campaign of 1929, has caught up with Theresa May and the Conservative Party and eroded its Westminster majority, leaving the UK facing the prospect of a coalition Government for the second time in three General Elections.

Going into the June poll markets had rather lazily been relying upon the opinion polls which continued to point to a Conservative win, so this unexpected development is likely to create some short-term volatility in stock, bond and particularly currency markets.

The markets have already been able to express a view on the hung Parliament result by trading sterling overnight in Asia and the pound has lost around 2% against the dollar, falling to around the $1.27 mark, retracing some of its recent gains.

In some respects, it could have been a lot worse for sterling and that may reflect the electorate’s rejection of, or at least failure to wholly embrace, the Prime Minister’s so-called ‘Hard Brexit’ stance.

However, the pound’s slide is leading to an action replay of last year’s post-EU referendum trading pattern. Today’s early moves saw the FTSE 100 rise and the more domestically-oriented FTSE 250 fall as stocks took their lead from the currency markets and the big multinationals and dollar earners moved higher.

It is noticeable that defensive names with overseas earnings – spirits giant Diageo, drug firm GlaxoSmithKline and food-to-personal care play Unilever – did best in the opening exchanges, to reflect the prevailing uncertainty.

The FTSE 100 laggards were more domestic names like ITV, the housebuilders and the banks, even if talk of a softer Brexit could play to the financial services stocks at some stage, assuming it proves to be more than just talk.

In the very short term, the identity of the next Prime Minister and the parties who form any coalition will go a long way to shaping sentiment, in addition to the rate at which any negotiations are concluded.

Back to 2010

Back in 2010, the FTSE 100 fell 2.6% on the day after the election on 6 May of that year threw up a hung Parliament.

The index then rallied 5.2% on the following Monday, when incumbent Prime Minister Gordon Brown resigned and overall recorded a gain of 2.3% from the day before the ballot to the announcement of the Conservative-Liberal Democrat coalition on 12 May.

In contrast, the UK Government bond (or Gilt) market wobbled a little, as the yield on the benchmark 10-year Gilt rose to 3.78% from 3.74% and prices therefore fell slightly.

Sterling lost between 1.5% and 2.0% against the dollar and euro on 7 May as the hung result became clear but losses came to barely 0.5% on each count by the time David Cameron and Nick Clegg had cobbled together their coalition.

The scope for short-term swings is clear – but note that markets calmed down pretty quickly as economic and company fundamentals reasserted themselves.

Over the 12 months following the 2010 election, the FTSE rose 13.6% while the 10-year Gilt yield fell (so price rose) from 3.74% to 3.40%, helped by the Bank of England’s Quantitative Easing bond-buying programme.

Stocks recovered their poise quickly as the coalition settled in after the 2010 election ....

Source: Thomson Reuters Datastream

.... as 10-year Gilt yields continued to fall (and prices to rise)

Source: Thomson Reuters Datastream

The pound gained 10% on the dollar and lost 4% against the euro in the 12 months after the poll.

... and the pound rose against the dollar and fell against the euro

Source: Thomson Reuters Datastream

The presence of a Conservative leader in Number 10 Downing Street may have helped here, but the fundamental backdrop was one of recovery from the financial crisis and ultra-loose monetary policy from central banks the world over, in the form of falling (or record-low) interest rates and QE.

Safety first

“Safety First” may have done for Stanley Baldwin in 1929 but for investors it should still be a helpful mantra.

The prompt rally subsequent to the initial chaos in June 2010 shows that fund managers will be better off focusing on company and economic fundamentals rather than trying to second-guess short-term political developments and market movements. And since fund managers should be sticking to their mandates and established strategies, advisers and clients will be able to do the same.

Certain sectors or individual firms could be affected by short-term shifts in policy – banks, transportation companies and utilities all have the potential to become (or remain) political footballs.

Which sectors end up in the firing line – or at the head of the queue for more emollient treatment – will depend upon who ends up leading, and forming, the coalition. This is not to overlook the role of the Scottish National Party, Plaid Cymru or the Northern Irish parties, all of whom could have a role to play, too, especially Belfast’s Democratic Unionist Party (DUP).

The DUP is already making its determination to drive a hard bargain very clear, especially as Northern Ireland will have the UK’s only physical border with the EU in a post-Brexit world.

And that takes us to the elephant in the room - Brexit.

As he or she enters Number 10 Downing Street, the next PM now has two years to negotiate a deal with the EU – or decide whether to walk away without one, and perhaps rely on the World Trade Organisation (WTO) status which already serves us well in our trade relations around the world, with everyone from America onwards.

Some advisers and clients will think the stock market is too relaxed about what Brexit may mean for the economy and UK plc’s earnings power. They might fight shy of British stocks or the pound, or at least sectors with a hefty domestic bias, such as construction, property, retailers and financial services providers.

Others will think that there is too much gloom about what Brexit may mean and that there could be an upside surprise. In that case, these advisers and clients may prioritise British stocks over overseas-quoted ones, or those dollar-earners and UK firms with big overseas exposure, such as miners and engineers, preferring the home comforts of banks, construction, retail and real estate.

It is also now possible that markets will start to price in a ‘softer’ Brexit now that Mrs May’s ‘hard Brexit’ stance has apparently been rejected, or at least seriously questioned, by the electorate.

Back to Basics

Advisers and clients might also like to bear in mind another political slogan.

“Back to Basics” formed part of a keynote speech by then Conservative Prime Minister John Major in 1993. Admittedly it did him little good, as he was swept out of power by a landslide in 1997 – but as a mantra it should serve investors much better.

Securities prices and currency movements are not just driven by political considerations. Far from it, as two other – far more – important factors are at work.

The first is corporate profits and cash flow, which are themselves shaped in the short term by macroeconomics and in the long term by industry dynamics, a company’s competitive position and boardroom acumen. Government policy and regulation can have a role to play here but they are not the only factors at work, as a company’s customers and competitors can be just as influential.

The good news is that analysts’ consensus forecasts, in aggregate, for the FTSE 100 suggest that company earnings are going to rise sharply in 2017 and then advance more modestly in 2018.

The good news is FTSE 100 profits are expected to rise sharply in 2017 ...

Source: Digital Look, consensus analysts’ forecasts

In addition, dividends are expected to rise for the seventh and eighth years in a row respectively in 2017 and 2018, enough for a 3.9% dividend yield this year and 4.3% next.

... and dividends are expected to progress this year and next as well

Source: Digital Look, consensus analysts’ forecasts

Yet advisers and clients must test the quality of earnings as well as the width.

For 2017, mining and oil and gas are forecast to contribute 51% of expected earnings growth between them – but commodity prices are rolling over and the pound is gaining on the dollar. These are both negatives for these sectors and those forecasts.

Financials are a further 24% of the expected earnings uplift this year – so everything else is pretty much noise.

Miners, oils and financials dominate the consensus earnings growth forecasts for 2017

Source: Digital Look, consensus analysts’ forecasts

When it comes to dividends, mining is 33% of the forecast increase in 2017, financials 25% and oil and gas 15% (again due to a weaker pound).

The same three sectors are key to consensus dividend growth forecasts in the FTSE 100 too

Source: Digital Look, consensus analysts’ forecasts

Once the initial kerfuffle caused by the appointment of a new Cabinet and the commencement of Brexit talks passes, it is these sectors and these issues – sterling, the oil price, metals prices and whether the banks can keep their noses clean – that will really determine where the UK market goes.

Price must be right

If corporate profits and cash flows are one consideration that has the final say in where securities prices or indices go, then the second is valuation, and the price advisers and clients are prepared to pay to access those profits and cash flows, via their selected active or passive funds and their managers.

In crude terms, a forward price/earnings (PE) ratio of 15.3 times for 2017 and 14 times for 2018, based on aggregate consensus earnings forecasts for the FTSE 100, is neither unduly cheap nor unduly expensive relative to the index’s 33-year history.

Another long-term metric is less encouraging. On a market-cap-to-GDP basis UK stocks have rarely traded as expensively and are in territory from which they have historically found it hard to make sustainable progress.

UK stocks look relatively costly on a market-cap-to-GDP basis ...

Source: Digital Look, consensus analysts’ forecasts

Bulls will however draw comfort from the dividend yield. At 3.9%, it stands way above the 0.98% available on 10-year Government Bonds, or Gilts. That 290 basis point (2.9%) premium is historically very high and a potential source of support for stocks, even allowing for the caveats that marked weakness in oil, the dollar and metals prices could impact forecast dividend growth and that earnings only cover the dividend payments by around 1.7 times (two times or more would provide more comfort).

... although the premium yield on stocks relative to Government bonds could support share prices

Source: Digital Look, consensus analysts’ forecasts

This suggests that it may take a major move higher in inflation – and therefore Bank of England interest rates and bond yields – to derail the bull market that began in 2009, even if it is oils, miners and banks (rather than politics) that will dictate how far it goes from here.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.

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