Mark Martin discusses the potential implications of the upcoming general election on the UK economy, sterling and the UK equity markets
There is a strong expectation the Conservatives will secure a big majority in a general election that is now only six weeks away, which should put the Prime Minister in a stronger position during Brexit negotiations.
Sterling has strengthened significantly as a result and domestic cyclicals have rallied in the immediate aftermath of Theresa May's shock announcement, while more internationally facing companies have broadly underperformed.
The more domestically-focused FTSE 250 has significantly outperformed the FTSE 100 since the announcement, and is now ahead by more than 7 percentage points in 2017.
More recently within the FTSE 250, companies with a domestic focus have outperformed those that derive their earnings from overseas. There was initially a lot of indiscriminate selling of small and medium-sized companies after the vote for Brexit last June, which we have started to see reverse in recent months.
While the UK economy remains in good shape, we do not believe sterling is likely to strengthen significantly from here, and continue to have concerns over the risk/reward equation in domestic cyclicals.
With expectations for a Conservative landslide so high, any other result could see a sterling correction. Indeed, even if the Conservatives do secure a big election win, the path for Brexit remains extremely uncertain. The only way we see sterling strengthening significantly from here is if the Prime Minister is able to maintain the UK's position in the single market. This seems highly unlikely given the hard-line stance of EU leaders, who have repeatedly emphasised they will not allow the UK to have freedom of trade without consenting to the free movement of labour.
Signs UK economy is slowing
Moreover, there are signs the UK economy is slowing. The timing of May's announcement was shrewd not only from a political perspective - Labour has never been weaker relative to the Tories - but also from an economic perspective.
Real wage growth has been positive for some time, but the most recent data point showed a slight decline. With inflation expectations increasing, negative real wage growth could have a knock-on effect on GDP growth and consumer confidence. Recent data showed UK retail sales recorded their largest decline in seven years in the first quarter of 2017 while house price rises, particularly in central London, have also started to slow.
We therefore retain our preference for internationally facing UK midcap companies, many of which have yet to benefit from sterling weakness since the Brexit vote. We have taken the opportunity to top up positions in some of these companies since May's announcement, and remain optimistic about their potential to generate attractive returns on a medium to long-term view.
Conversely, we are generally cautious about domestic cyclicals - not only because of the potential slowdown in the UK economy, but because many of these companies are expensive relative to history. This includes the housebuilders, which we continue to avoid in the portfolio.
We are finding select opportunities however, and have recently initiated a position in specialist lender Aldermore, which is currently trading on just 8x next year's earnings and valued at only slightly above its book value.
Mark Martin is head of UK equities at Neptune Investment Management
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