Don’t panic! But maybe keep your tin hat close by

Are political surprises and uncertainty now the new normal? It could appear that way after yesterday’s general election resulted in a hung parliament after the ‘dead cert’ Conservative majority predicted just seven weeks ago.  The Conservatives have emerged as the largest party and are seeking to form a minority government with the support of the DUP.

Stockmarkets so far have been remarkably sanguine – the biggest reaction has been in the currency markets with sterling seeing an initial drop of 2% against the dollar overnight. Even this is small in the context of the 15-20% plunge following the Brexit vote in June last year.

The Prime Minister, Theresa May, earlier today confirmed that the Brexit negotiations will begin as planned on 19 June. The question that will dominate markets is whether or not this means a softer Brexit. Investors might be buoyed by the possibility of a softer Brexit, but the uncertainty over what the UK negotiating position is going to be will weigh on sentiment. While sterling looks to have priced in much of a hard Brexit risk before the vote, the currency will likely continue to experience volatility through the governmental and Brexit talks.

The FTSE 100 large-cap index has been strongly driven by currency moves since the UK’s vote to leave the EU. The experiences from Brexit suggest that the FTSE 100, given the majority of companies in the index have significant overseas revenues, is affected more by the moves in sterling, than the uncertainty plaguing the domestic economy. A weaker sterling favours those companies with international earnings.

However, the FTSE 250 index has underperformed the FTSE 100 by c. 3% in recent weeks, suggesting that investors had started to factor in election risk. The increased uncertainty could hamper prospects for domestically-focussed UK stocks and the FTSE 250, with foreign exchange moves impacting their profit margins and the real disposable income of their customers.

For global investors, UK stocks represent a cheap market (on both earnings yield and a historical P/B basis) in a cheap currency.  Additionally, the lower beta FTSE 100 is attractive to investors seeking growth and yield as the reflation trade continues to wane. However, higher political uncertainty is likely to offset the benefit from a marginally weaker pound.

From a sector perspective, companies with predominantly domestic earnings are vulnerable to import price inflation. Rising import costs tend to be strongly negatively correlated with consumer stocks and more domestic-facing company performance. The unexpected election outcome could therefore weigh on company shares with a high UK exposure.

Despite the noise and immediate uncertainty, it is however important to look beyond the politics and not to have a ‘knee-jerk’ reaction. The UK election is happening against a positive and supportive background for global markets, with accelerating global trade and the global growth story still intact. In the first quarter, we had a record earnings season, the best in over six years, and the economic backdrop is supportive of continued earnings growth, which should help sustain the equities rally.

The likely volatility in the UK market over the forthcoming days from the narrower-than-expected election outcome could spark some interesting opportunities for selective investors. It’s important however, to focus on the longer-term outlook – the shape of the Brexit negotiations, their impact on sterling and the outlook for global growth.