Downgrade British Shares a Notch to Market-Weight Pending the Outcome of the May 7th Vote

A combination of three percent growth in real GDP, 4.7 percent year-to-date equity market total return in US dollar (nine percent in sterling) terms, fifty percentage point reduction in the public debt-to-nominal GDP ratio to 98 percent and five point contraction of the budget-to-nominal GDP quotient to ten percent would normally make Great Britain the envy of any economy were it not for forthcoming parliamentary elections that appear to be signaling a further fragmentation of national politics that imperils the scrupulous budgetary posture of the current Conservative (Tory)-Liberal Democratic coalition.  Having effectively reversed the course of fiscal deterioration, successfully engineered a vigorous economic recovery and victoriously triumphed in the Scottish Nationalist referendum, the Tories would appear overwhelmingly worthy of another five-year mandate.

UK Leading Economic Indicators, Ten-Year Gilt Yield and FTSE 100 Positive-Adjusted Price/Earnings Ratio Trends

However, pre-election polls are indicating a decidedly different outcome.  The United Kingdom (UK) is facing a further splintering of the nation’s political power base.  Even though the opposition Labor party is likely to lose almost all its seats in Scotland to the Scottish National party (SNP), broadly shared interests between the two, and possibly the Liberal-Democrats, of mainly a “cradle-to-grave” nature – in light of recent survey results – makes a coalition between Labor and SNP a virtual certainty and among all three a distinct possibility.  Tory leaders (Prime Minister David Cameron and Chancellor of the Exchequer George Osborne) had been focusing on avoiding a rupture in their own party by counteracting the appeal of the UK Independence party (UKIP) and placating Tory euro-skeptics with a pledge to hold a plebiscite on UK membership in the European Union (EU).

Great Britain Sovereign Gilt Yield Curve

So, why is the Tory re-election campaign struggling to get its message across to the public? One incontrovertible fact is that the rebound in the macro-economy has had insufficient time to diffuse wage and employment gains throughout the country.  True, the national jobless rate has plummeted approximately three percentage points in less than four years to 5.6 percent and nearly all gender and age groups have benefitted to one degree or another.  Yet, not all localities in Great Britain are participating in and deriving advantages from the upturn.  Indeed, the inability of nominal wage growth to breach the two percent level sustainably explains the hesitation of the Bank of England (BoE) to normalize monetary policy after years of aggressive credit accommodation.

Bilateral US Dollar-to-UK Sterling (USD/GBP) and UK Sterling-to-Euro (GBP/EUR) Trends

In the event UK voters decide not to reward the Tories with an outright majority or even a sizable plurality of parliamentary seats with which to form another coalition government, what course could policymaking take if a Labor-SNP ruling alliance were to emerge in the May 7th election?  While both parties have paid the obligatory lip service to budgetary discipline during the campaign, their politically expedient promises to elevate spending for education and a host of other social programs contradict any fundamental notion of fiscal probity other than their repeated promises to legislate higher taxes on the nation’s wealthy.  Labor’s long-standing left-leaning biases and budgetary recklessness – except under Premier Tony Blair – are a matter of historical record, but a coalition of Labor and SNP, which subscribes to socialism more ardently than its likely partner in power, would put the UK on an uncertain fiscal path that could threaten its enviable triple-A credit rating.

Britons need only recall the financial events nearly forty years ago (1976) that led Washington to help arrange a currency stabilization package for the UK via the International Monetary Fund (IMF).  Under the leadership of then Labor Prime Minister James Callaghan, Great Britain had undergone a dramatic deterioration in the state of its economy as inflation (exceeding fifteen percent then) surpassed that of its main trading partners and growing external payments imbalances destabilized sterling.

Stagflation, anemic growth accompanied by hyperinflation and double-digit joblessness, worsened the financial plight of the country already mired in deep fiscal shortfalls and soaring debt levels.  Ruling party centrists and extreme leftists acrimoniously debated a modest austerity proposal that was defeated in parliament, causing Callaghan’s predecessor – Harold Wilson – to resign.  Policy drift soon became apparent to investors, who promptly sold off the currency and instigated intervention by the US to arrange a $3.9 billion loan through the IMF to rescue the pound from currency speculators.  Most notably, the bailout of Great Britain in 1976 marked a watershed change in the IMF’s negotiating posture, demanding stringent conditionality and heightening its interventionist profile henceforth.

UK Sterling Real Effective, Trade-Weighted Index, Terms of Trade and Current Account to Nominal GDP Trends

Bearing in mind the events of 1976, investors should not conclude their recurrence unimaginable, especially under a probable Labor-SNP coalition or a possible Labor-SNP-Liberal Democratic alliance in the wake of the ballot two weeks from today.  Either of the two political formations should rightly arouse concerns about the future fate of the British economy.  A bidding war of late among the three parties over which one could offer the highest public sector wage increase was startling particularly in light of the achievements of the Conservative-Liberal Democratic coalition government to restore competitiveness through productivity gains and cost cutting.  Needless to say, if any of the two political alliances sets off in a resolutely divergent direction fiscally from the present regime, it could put the UK on course for a review and possible downgrade of its prestigious credit rating.

Regardless of which party or combination of parties assumes power in Westminster next, economic conditions, government finances and policymaking climate are on a solid footing, mirrored by strong investor confidence and a comparatively high FTSE 100 positive-adjusted, one-year forward price-earnings ratio (p/e) of 16.6x in pound terms, which exceeds its twenty-two year 16.0x historical average.  However, the FTSE 100’s p/e looks modestly appealing on absolute and relative valuation bases across all of Western Europe, country-by-country and compositely.

Nevertheless, mounting concerns about the fiscal fate of the UK under one of the two center-left coalitions that could emerge in the form of a government as a consequence of post-election negotiations are taking their toll on investor credence in the forthcoming policymaking environment.  Rising implied volatility on one-week, at-the-money USD (US dollar)/GBP (sterling) options since late last year and the sell-off of gilts across all durations – though their returns are still fractionally positive in pound terms, but negative when denominated in US dollars – stand in sharp relief from the 8.5 or 4.6 percent return on equities valued on either a sterling or a US dollar basis, respectively.

Our concern about a potential future economic dilemma is fully justified by the campaign rhetoric of the Labor, SNP and Liberal Democratic parties, all vying to unseat the Conservatives in the May 7th elections.  If any of their political oratory were to materialize in the form of official policy, sterling could come under a great deal of downside pressure as will the bond and equity markets.  As a precaution against such a possible eventuality, a lowering of exposures of UK stocks and bonds from an over- to a market-neutral weighting and a shortening of duration of sovereign debt holdings are imperative until greater clarity prevails in the aftermath of the vote.

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