2015 – a double election year?

2015 looks set to be a particularly political year, with the possibility of there being two general elections looking increasingly plausible. In the last six months, the strong performance of UKIP in the European elections and the SNP in the referendum vote, have seen UK politics move from the three party affair thrown up by the 2010 election (itself a radical departure from the two party politics naturally favoured by a first-past-the post system) to one where the fortunes of five different parties need to be considered to determine the final outcome of the 2015 election. One could add the Green party as a sixth, given their existing one seat and recent improvement in the polls.

In a constituency system with just one vote, a candidate merely needs more votes than any other candidate, and does not need the support anything close to half the electorate to win. In a 4-way competition, just 25.1% could theoretically be sufficient to win the seat. Thus the impact of new parties drawing votes from existing parties can make predicting the winner of any individual constituency incredibly difficult.

UKIP are currently showing at 17% in the opinion polls, with their support being drawn approximately ¾ from former Conservative voters and ¼ from former Labour voters. This could be enough to win a handful of seats, but the more important national impact could be the split in the Conservative vote allowing Labour to win some individual constituencies where they would not otherwise expect to have sufficient support.

The interest and passion displayed by the Scottish electorate in the independence referendum has continued since then and the SNP has in recent polls been drawing huge support from former Labour voters in Scotland, where Labour currently holds 41 seats, which are now under threat.

Support for the Liberal Democrats collapsed from the 26% achieved in 2010, from the moment they reversed stance on student fees in the initial Coalition Agreement. Their 7% showing currently in the opinion polls is very poor but their MPs tend to have built large local support bases in their constituencies and they are likely to win more seats than their national support would suggest.

The two major parties have not between them garnered the support of more than 2/3 of the electorate since the last election campaign (in 1945 they took 95% of the vote, but have been in decline since then). The current distribution of constituencies favours Labour, who hold many inner city constituencies where the size of the electorate has shrunk over the years, whereas Conservative constituencies are more concentrated in the suburbs where electorates have been rising.  Until recently, most analysts believed that Labour could win a parliamentary majority with just 35% of the national vote, whereas the Conservatives needed to win about 40%.  The recent rise of UKIP and the SNP probably means that these estimates need to be increased.

On current YouGov forecasts, not only will neither Conservatives nor Labour win a majority of seats, a coalition of either party with the Liberal Democrats will also not produce a parliamentary majority. The most likely outcome of the May 2015 election is thus a second election in October/November next year.

Opinion polls do fluctuate and there are still almost six months until the poll that matters, but the electoral arithmetic against a stable outcome looks difficult to overcome. For UK financial markets this may be troublesome in 2015.  This was always likely to be the case as a Conservative-led government would be committed to holding a referendum on EU membership in 2017, which would generate huge uncertainty in the minds of business with regard to investment in the UK, whilst a Labour-led government would be led by Ed Miliband, who would be seen as the most left-wing and anti-business Prime Minister that the UK has seen.

It is difficult to work out what a good election outcome would be for the financial markets.

A Quietly Profitable First Half

At the beginning of 2014 we forecast that investing in markets this year would be less profitable but more volatile than in 2013. So far in 2014 the first aspect of our forecast has been borne out, with most asset classes showing total returns of between 0% and 5%, the major exception being UK commercial property with a total return of about 8%. However, markets have become less and less volatile and investors have become progressively more comfortable about the outlook for market returns. We continue to expect volatility to increase in the second half as the time for interest rate increases in the US and the UK is nearing. This note explains our views on recent market developments and the rationale for our tactical asset allocation positions for the second half, which remain Smaller Company Shares and Commercial Property in the UK, and Asian and Japanese Company Shares.

The first half of 2014 in financial markets can best be described as “quietly profitable”. It was profitable in that both bond and equity markets provided investors with modest gains (in low single digits). It was quiet in that markets did so with very little volatility or drama; in addition, transaction volumes in most financial markets have been surprisingly low, as investors, who have little desire to hold cash, which earns little to no return are struggling to find attractively valued investments to purchase. However, most economic and geo-political developments during the first half are more easily interpreted as negative rather than positive for markets, as follows:

  • The IMF has reduced its forecast for global GDP growth in 2014 from 3.8% in January to 3.4% in June, principally due to weak performance from the US and China, which are the world’s two largest economies. In the US, this has been ascribed to dreadful weather in the first quarter, which led to a contraction in the economy over that period; for example, the Goldman Sachs estimate of Q1 growth in the US has been revised down from 3% in January to -2%. The authorities in China have changed tack and are now seeking quality rather than quantity in their GDP growth. They are allowing the private sector rather than the public sector to lead economic development, which should mean that growth is based on profit-maximisation rather than employment-maximisation.
  • In both the US and the UK, the central banks are moving away from the extraordinarily easy policies of the last five years. In the US, the QE programme is being steadily reduced and is likely to have ended by Q4 this year, while in the UK, the rapid fall in unemployment has meant that markets now expect an interest rate increase by year end. These reversals in policy direction are likely to prove to be a headwind for both bonds and equity markets during the second half.
  • In Europe, the rate of inflation has fallen to extremely low levels. Over the Eurozone as a whole it is now 0.5%, but for many of the weaker economies it is now negative, creating a problem for debtors as the real burden of their debt increases. The ECB produced a raft of technical measures to loosen its policy, including negative interest rates on deposits left at the ECB by the banks, but failed to announce the QE programme which the markets believe will be required.
  • The Russian annexation of Crimea and the subsequent uncertainties in Ukraine have highlighted Europe’s dependence on Russian gas and on the goodwill of President Putin. The Western powers have found no meaningful response to Putin’s actions. Their dilemma was reinforced by the announcement of a 30 year deal for Russia to supply gas to China from 2017, the implication of which is less availability of supply to Europe – and less reliance of Russia on its European gas customers.
  • More recently, the Islamic State uprising in Northern Iraq has also left the West struggling to formulate a response, and it is clear that there is no longer any political will to commit significant numbers of troops on the ground or intervene in such troubled areas. However, Iraq is the world’s second largest oil exporter, and a threat to production in Iraq is likely to lead to a sharp rise in the oil price.
  • Following May’s European parliamentary elections, about 25% of the MEPs now represent anti-EU, anti-Euro parties. This is not enough to force any change in Brussels, but should send the message to Europe’s politicians that the political choice in most of Europe between abandoning austerity or remaining in the Euro, is beginning to move against the Euro. France and Italy are the two countries where this key political decision is being increasingly debated.

With bond yields having declined and share prices having risen faster than corporate profits, financial markets have become less attractively valued over the first half of the year. In addition, there are indications that investors are becoming overly confident. US-based investment advisers are the least bearish they have been for several years, there is a record level of US shares bought on margin (that is with borrowed money) and the debt covenants accompanying recent non-investment grade corporate bond issues have become materially weaker. The levels of implied volatility in bond, equity and currency markets are all at the very low levels last seen in 2006/2007, suggesting that investors are ascribing a very low probability to any upsets in markets. History suggests that, following a five year bull market, such an assumption is fraught with danger.

Western equity and bond markets are thus vulnerable to setbacks in the second half. However, markets in Asia and Japan are more attractively valued, have better growth prospects and have investor bases who are much less complacent about the future than investors in western markets appear to be.

In the UK, the domestic economic recovery has continued to accelerate, though with little assistance from demand from the US or Europe, the UK’s two main trading partners. This domestic recovery is expected to continue and supports our emphasis on investments in commercial property and in smaller company shares, rather than mid-cap shares. Both property and small caps have performed poorly over the last decade but appear ready to make up for these disappointments through their sensitivity to the recovery in domestic spending.


Economic outlook

Five years on from interest rates being cut to almost zero in most Western economies, and the introduction of QE programmes in the US, UK and Japan, the global economy finally seems to be moving onto a more secure footing.  Risks remain though, particularly the high levels of government and consumer debt in most Western economies, which remain a constraint on future growth.  In addition, the weakness in inflation indices and continued high levels of unemployment, mean that a renewed global economic downturn, in the immediate future would be very damaging, as there would be very little policy flexibility to offset economic weakness.  Our regional views are as follows:

  • The UK economy has been recovering strongly since last spring when the Help to Buy scheme was announced.  This recovery has been led by housing and mortgage demand, rather than by the business investment that is required for a healthy and sustainable economic recovery.  However, the consumer can drive a continued recovery through 2014 and up to the 2015 election, if savings rates continue to fall.
  • The US economy has entered 2014 growing at a near 3% pace, and this is expected to continue for 2014.  As in the UK, business investment is still a problem, as companies appear far more concerned with growing dividends and buying back shares to boost their share prices than by investing for future growth.
  • The European economy is still struggling. Growth should be positive in 2014 after close to zero in 2013, but recovery will be constrained by continued austerity by most governments, negative inflation rates in many peripheral economies, and by banks still seeking to reduce their loan books ahead of the ECB’s Asset Quality Review later in 2014.
  • The Japanese economy continues to respond to Abenomics.  The increase in the National Sales Tax from 5% to 8%, which will take place in April, will mean a strong first quarter but a weak second quarter.  However, the Bank of Japan has indicated that it is ready to increase its already large QE programme to mitigate any economic weakness.
  • In Asia, Chinese growth is slowing as the  authorities there are seeking a rebalancing of growth away from the wasteful over-investment seen in recent years towards greater consumer spending.  Higher wages have been a key part of this, but this has been funnelled into property speculation rather than consumption.  The central bank is trying to deflate the housing market without deterring the consumer from spending.
  • Other emerging economies are facing problems as the improvements in growth elsewhere are impacting the flows of financial market liquidity, which have been supporting them.  Current account deficits in Brazil, Turkey and South Africa, are now causing falls in their currencies and higher interest rates in response, which will lead to weaker growth in 2014.

2014 should see the world economy move back towards a more normal pace of growth.  For central banks, the dilemma is when to move back to more normal settings for monetary policy.  We believe that official interest rates are unlikely to rise in the West during 2014, as it is likely that central banks will err on the side of risking creating inflation rather than risking creating more unemployment.

Markets outlook

Entering 2014, the consensus amongst most investors on the prospects for the global economy and for stock markets in 2014 is one of greater optimism than for several years.    However the two factors of improved economic prospects and stronger financial markets, do not necessarily occur simultaneously.  Indeed, stronger economic growth has already led to the Fed tapering its QE programme, and investors bringing forward their expectations of when interest rates will begin to rise.  Typically, the financial markets perform well in expectation of improved growth, but when that growth appears, the liquidity in the financial markets is then needed by the real economy for investment.  This tends to mean rising bond yields and falling P/E ratios, and subdued investment returns.

For the UK markets in particular, the domestic pension funds have experienced a significant improvement in their funding position from the combination of rising equity prices and rising bond yields. Many schemes are being advised by their actuaries to take advantage of this improvement and to “de-risk” their portfolios by reducing equities and buying index-linked bonds.

Within bond markets, we are not particularly hopeful of much in the way of returns in 2014, and hold UK index-linked bonds for their favourable tax treatment, and the option they provide should UK inflation expectations increase.  Emerging market government bonds issued in US dollars now offer attractive yields for the level of credit risk that they bring (such as those witnessed in the recent poor economic developments in Turkey and Argentina).

We favour UK commercial property, where we believe that the market cycled has reversed from falling rents and capital values to one where rents and capital values are rising.  The yields on commercial property are also attractive compared with those available on bonds and equities.

Within equity markets, we favour: (i) Japan, but with the yen exposure hedged, as the Bank of Japan will continue to print money until economic recovery and inflation appear well-set; (ii) UK smaller companies, which for many years have not delivered the extra performance over large and medium-sized companies normally achieved from such investments – the current strength we are witnessing in the UK domestic economy should be reflected in better performance from smaller companies;  and (iii) Asia, where valuations are historically below average in absolute terms and long term growth prospects remain strong.  We have a neutral view on the larger companies in the UK equity market, with valuations on the FTSE100 Index near their long term averages.  The market would benefit from weakness in the pound, as profits in the second half of 2013 have been hurt by the strength of Sterling against the Dollar, Euro and Yen.  We expect the Dollar to be the strongest currency in 2014, but would expect a stronger Pound against the  Euro and Yen.

We are more cautious on the US and European equity markets.  In the US, corporate earnings expectations are already very high, and the valuations on those expectations are also at historically high levels, so strong performance from US equities will be difficult to achieve.  In Europe, in addition to high expectations of earnings growth and above-average valuations, as in the US, the growth outlook also remains subdued, bringing an extra degree of risk to European share prices.

We expect equities to outperform bonds during 2014, as they did in 2013 but expect the year to be both less profitable and more volatile for investors.