UK Election – Large Conservative Majority


Conservative majority Government guaranteed, forecast to be 74 seats
At 5.08am UK time, the Conservatives passed the mathematical threshold of 325 seats
required to guarantee an absolute majority Government. Current projections are for a
final majority of 74 seats, far bigger than pre-Election forecasts and an outcome that
will give the Prime Minister significant room for manoeuvre in the next phase of Brexit
negotiations over the UK’s future relationship with the EU.
Economics – modest Q1 relief, but renewed fading and a 25bp rate cut in May
This outcome should provide a boost to consumer and corporate sentiment supporting
a rebound in GDP growth in early 2020. However, with an 11-month transition period

likely too short to finalise a new trade agreement, we expect the return of Brexit-
related uncertainty to slow activity in H2. We continue to expect GDP growth to slow

from 1.2% in 2019 to 0.9% in 2020 and the BoE to cut Bank Rate by 25bp in May.
FX – Sterling surged to an intraday high of $1.351 from $1.317 at 10pm
Responding to the exit poll prediction of a large majority for the Conservatives, cable
surged from $1.317 to a high of $1.351, its highest level since May 2018. With the
drawn-out uncertainty over the Article 50 process now set to be swiftly removed with
the new Parliament expected to ratify the deal agreed with the EU in October before
the end of January deadline, we expect sterling to hold onto most of these gains and
consolidate around $1.34-1.35.
Rates – front end may unwind rate cut expectations, but they will soon return
We expect this decisive outcome to deliver a short-term boost to sentiment and
confidence in Q1 as uncertainty is lifted for a time, but with the transition period lasting
less than a year, we think fresh uncertainty over Brexit will start to cool demand again
later next year. The front end is likely to sell off initially, but in our view will soon start
to price in a growing possibility of a cut by mid-2020. The 2s10s sector of the curve
should steepen, while we expect the longer end to outperform the belly on relief that
Government borrowing and Gilt supply should remain under control.
Equities – domestic stocks will likely outperform in the near term
Given the extent of the rally in sterling, we suspect the FTSE 100 might not perform
that well in local-currency terms (c.80% of revenues come from overseas). We would
focus on domestic stocks: although these have outperformed since early September,
they are still down 21% relative since the EU referendum and 40% since pre-financial
crisis. Additionally, broader European equities may also perform well, particularly the
Banks, as these have been correlated to « no-deal » Brexit risk.
Credit – a game of two halves
The expected short-term GDP boost in early 2020 will cause further spread tightening
in GBP IG and HY markets to 115-125bp and 390-410bp in the short term. The upside
will likely be capped by uncertainty over the EU-UK trade negotiations in H2, which we
expect to push spreads towards our revised end-2020 targets of 150bp (IG) and 585bp
(HY). We prefer GBP HY over IG on a tactical basis in the first half of the year, but IG
over HY for the full year based on excess return projections of 0.76% and 0.49%
Link to our comprehensive analysis of the outlook for Brexit
One of the consequences of this Election outcome is significant clarification of the likely
next steps in the Brexit process. We discuss the main implications in this report, while
our in-depth analysis and forecasts can be found in the Q-Series report we published in
October entitled « Brexit: What’s Priced & How to Position Along the Paths Ahead ».


UK Election – Conservatives elected with a large majority
At 5.08am on Friday 13th December, it was confirmed that the Conservatives
had reached the 326 seats needed to confirm an absolute majority
Government for the next five year Parliamentary term. With 65 constituencies yet
to declare, the (BBC) forecast final number of MPs for each party stands at 362 for
the Conservatives (v 317 in the previous Parliament), 199 for Labour (262), 52 for
the SNP (35), 13 for the Liberal Democrats (12), and 24 for other parties (24).
Figure 1 shows seats won as at 5.08am, and projections for the final outcome.
If current projections are accurate, the Conservatives will end up with a
majority of 74 seats, much larger than pre-Election estimates anticipated and a
result that will give Boris Johnson significant room for manoeuvre in negotiations
over the future relationship with the EU. His authority will be materially
strengthened by the scale of the win, while the influence of the more ardent
Brexiteers in his party will be diminished. This has clearly been interpreted by FX
markets in the initial response as a more comprehensive outcome than
expected, with the dramatic rally in sterling reflecting the imminent lifting of
Brexit uncertainty, at least with regard to the Article 50 phase of the process.
With the obstacles previously presented by operating as a minority Government in
a Parliament with few natural allies – particularly in respect of Brexit – now
removed, we will now see swift Parliamentary approval of the deal struck
between Boris Johnson’s Government and the EU in October, followed by
ratification and the UK’s formal, legal exit from the EU by the end of
January. It will also be confirmed that the UK will then enter a transition
period, initially until the end of 2020, during which negotiations on the full
details of the future relationship and trading arrangements will be conducted. We
believe this will prove too short to reach a comprehensive agreement, and expect
an extension to be requested and granted in due course.
However, we expect any such request from the UK Government to come
significantly later than the 1st July interim date provisionally agreed in the
Political Declaration. The Conservatives have repeatedly committed during the
Election campaign not to request an extension to the transition period, and as any
such request will from now on be voluntary rather than reluctantly forced by the
intervention of Parliamentary opposition we expect it only to materialise when
it is abundantly clear the future relationship will not be fully determined
by the end of 2020, thus very late next year. Some in Government are also likely
to think that concessions are more likely to be forthcoming from the EU side if they
believe there is a genuine, imminent threat of the UK leaving without a deal, and
that belief will only crystallise towards the end of next year.
Although we do ultimately expect an extension if required, the longer
uncertainty persists over whether it will in fact be requested, the more
pronounced the likely renewed loss of momentum as investment, confidence
and sentiment slow during the second half of 2020. It has been clear throughout
the Article 50 negotiations that domestic private sector demand incrementally
cools the closer any deadline has come without clarification of what will happen
next, and the same is likely to happen again next year, in our opinion.


While uncertainty is therefore expected to resurface in due course, for the time
being the impetus for UK markets will come from the short term clarity
afforded by this Election outcome. The largest majority for a Conservative
Government since 1987 ensures the UK will leave the EU by the end of January,
while a Budget provisionally scheduled for March will likely see a modest fiscal
loosening but no significant shift in the existing policy path. The chances of
another EU referendum fall away, while the combination of the UK imminently
leaving the EU and the SNP on course to make significant gains in Scotland will
likely lead to renewed demands for another independence referendum in due
course. The Conservative Government will not support such demands but pressure
is likely to intensify over time.
The exit poll and early results materialised while UK markets were all closed, with
the currency providing the only real-time barometer of the implications of the
result. When markets reopen, we expect to see higher yields across the curve
on a combination of diminished near term rate cut prospects and a lifting of safe
haven demand. We expect the mid-sector of the curve to underperform, with
the long end in particular offsetting some of the potential rise in yields by
responding positively to the lower medium term borrowing expectations that are a
consequence of the election of a majority Conservative Government.
We think sterling has swiftly priced in the lion’s share of the overall
appreciation we think justified by the change in the UK’s political landscape, and
expect consolidation round current levels rather than significant additional
appreciation. GDP growth is seen accelerating in early 2020 on a modest
release of pent up consumption and investment demand, though the difficulties
that lie ahead in the negotiations over the UK’s future relationship with the EU are
expected to exert fresh headwinds from the middle of next year.
There are mixed implications for UK equities, with the negative impact of a big
jump in sterling on the majority of FTSE-100 earnings coming from overseas
contrasting with a likely strong performance by domestic stocks reflecting the
lifting of the uncertainty over the current phase of Brexit. We expect IG and HY
credit spreads to tighten materially in the early months of 2020, before
widening into the rising doubts about what will happen at the end of next year
if the UK and EU have not concluded trade and future relationship negotiations.


Economy – Q1 relief, then fresh slowing as concerns
The election of a majority Conservative Government brings short-term clarity to the
Brexit outlook with the UK now set to leave the EU on 31st January, followed by a
transition period currently agreed to last until the end of 2020. This outcome is
expected to provide a boost to consumer and corporate sentiment, supporting a
rebound in GDP growth in early 2020. However, with the 11-month transition
period likely to prove too short to finalise the new EU-UK trade agreement, we
expect Brexit-related uncertainty to slow GDP growth in the second half of next
year. Overall, we continue to expect GDP growth to slow from 1.2% in 2019 to
0.9% in 2020 and the BoE to cut its Bank rate by 25bps in May 2020.
In the short-term, we expect the outcome of the election to provide a boost to
consumer and corporate confidence. Investment has been hit hardest by Brexit
uncertainty to date with its contribution to GDP growth falling to zero since the
Brexit referendum. Against this backdrop, consumption has been the key pillar of
growth supported by the strong labour market. However, more recently, concerns
about labour market resilience have started to emerge, with the number of
vacancies declining and hiring intentions weakening. Hence, an improvement in
sentiment could trigger some pent-up demand and investment. We expect this
relief to be short-lived with anxiety growing as uncertainty over the UK’s trading
arrangements with the EU after the end of 2020 mounts from mid-year.Although the Political Declaration agreed with the EU stipulates that the British
Government should request an extension of the transition period by 1st July if it is
clear by then that the deal will not be finalised by the end of the year, we do not
expect Mr Johnson to make such a request until much closer to the deadline. We
do expect an extension to be both necessary and, ultimately, agreed, but until that
is confirmed, uncertainty about future EU-UK trade relations is likely to once again
weigh on sentiment leading to slower investment and GDP growth more broadly.


In terms of spending, the Conservatives plan to spend an additional £10bn (0.5%
of GDP) over the course of the next four years. The plan is set to be marginally
back loaded with about £1.5bn (0.1% of GDP) additional spending in FY 2020-21
and just under £3bn (0.15% of GDP) p.a. until FY 2023-24. Planned tax cuts are
estimated to cost around £3bn per year, with the increase in the National
Insurance threshold to £9,500 accounting for most of it (£2.2-2.5bn or 0.1% of
GDP). Finally, the Conservative manifesto laid out a four-year public investment
plan with total capacity of £80bn (around 4% GDP) but so far only £22bn (1.1%
of GDP) allocated. Similar to the spending plan, investment initiatives are
marginally back-loaded with £3.2bn (0.2% of GDP) of investments in FY 2020-21,
reaching £8.2bn (0.4% of GDP) in FY 2023-24.
The revenue to finance tax cuts and investment is expected to come largely from
savings made by leaving the corporation tax unchanged at 19% (rather than
cutting to 17%), worth cumulatively around £20.5bn (1% GDP) over FY 2020-24.
Overall, if the Conservatives follow through with their spending promises and the
revenue stream matches their expectations, net spending over the next four years
should be relatively modest at 0.2-0.4% of GDP p.a., which, assuming a fiscal
multiplier of 0.6, would add 0.1-0.2pp p.a. to UK GDP growth.
In our view, the Conservatives’ spending commitments are unlikely to be sufficient
to offset the negative impact of Brexit uncertainty, which we expect to return later
in 2020. Absent any surprise announcements at the upcoming Budget, now likely
taking place in February, we continue to expect GDP growth to slow down in H2
2020 as weaker sentiment weighs on investment once again. Against this
backdrop, a generally weaker global outlook, and our expectations of slightly
below target inflation, we continue to expect the MPC to cut Bank Rate by 25bp in
May 2020.


Rates – initially higher before subsiding again
ahead of a 25bp cut in May 2020
For most of 2019, there has been a close relationship between sterling and short
end interest rates in the UK, with periods of ebbing optimism around the Brexit
process typically coinciding with a decline in the currency and lower short end
rates, and vice versa when hopes have been raised (FIGURE 7). That relationship
has largely broken down since the start of October, in the wake of the EU exit deal
agreed by Boris Johnson, and the subsequent Election campaign which has
featured strengthening expectations – now realised – of a majority Conservative
Government and likely full agreement and ratification of that deal.
Over the past three months, sterling has rallied significantly, with the Bank of
England’s Trade-Weighted GBP Index gaining almost 7% (and GBP/USD up by
almost 8%) since the UK and EU agreed the revised Withdrawal Agreement and
Political Declaration. However, short end rates have failed to materially rise, which
we attribute to the coincident softening of a range of leading economic indicators
(including the PMIs, investment and hiring intentions, and the number of labour
market vacancies – FIGURE 10) suggesting the market agrees with our view that
even this outcome from the Election and a swift end to the current phase of Brexit
uncertainty will not materially alter the prospects for monetary policy and front end
rates. That said, there is likely to be a modest near-term rise in short-term rates as
inconclusive Election outcomes that would have triggered high volatility and
uncertainty, at least for a while, have been avoided.
Longer yields have been closely aligned with similar maturities in other advanced
economies all year (FIGURE 8) and we generally expect this to remain the case
going forward, though a temporary period of Gilt underperformance cross market
in the 10y sector is possible as risk aversion and safe-haven demand ease. We do
not expect this underperformance to spread to the long end, as safe-haven
demand is less prevalent at longer maturities. In addition, this Election outcome
confirms that the extant stance of fiscal policy should remain largely unchanged,
rather than swinging to a much looser stance had the Labour Party formed the
next Government, and had their manifesto commitments been put into practice.
Possible concerns over the amount of Government issuance over the coming years
should be assuaged, and we anticipate long end outperformance and flattening of
the curve beyond the 10y sector as a result.

The Conservatives announced during the Election campaign that if they won a
majority, they intend to hold a Queen’s Speech on 19th December, outlining the
policies and plans they hope to enact during the next Parliamentary session, and a
full Budget in February 2020. We expect the modest policy loosening announced
in their manifesto to add around 0.2% to annual GDP in 2020, and 0.4% in 2021.
That will not be enough, in our view, to offset the renewed economic cooling we
anticipate after a brief lifting of sentiment in Q1, as doubts about what can be
achieved in the 11-month transition period mount.
We expect markets to increasingly anticipate a 25bp rate cut from the MPC in
May, and reiterate our recommendation to receive the 1y swap rate, 1y forward,
targeting a move to 0.50% over the first half of next year. We believe that any rise
in short yields in the immediate aftermath of today’s Election result will present a
better entry level for this trade, rather than a reason to repudiate it.
We expect the 2s10s sector of the curve to bear steepen modestly in anticipation
of slightly easier monetary policy, which as well as exerting a mechanical
downward impact on short rates should cause yields to rise modestly in medium
tenors via expectations of better real growth and higher inflation expectations. The
10s30s sector of the curve is expected to flatten, partly in line with the usual
directional relationship with higher outright 10y yields, and partly due to the
relieving of pre-Election anxieties that a change of Government might bring about
much looser fiscal policy and a large increase in Gilt issuance over the coming
years. We reiterate our recommendation to pay the belly of the 2s10s30s swap fly,
which we entered at 2bp, targeting a move to 40bp, with a stop set at -18bp.


Equities – Focus on domestics…
While this outcome may remove some uncertainty, the likely move up in GBP/USD
may well offset part of the potential rally in the equity market. With c.80% of
revenues coming from overseas, there will likely be FX-related earnings
downgrades to come. But within the market we would have a clear preference for
the domestic plays. They have outperformed since early September (Figure 11) but
are still down 21% since pre-Brexit referendum and 40% since before the Global
Financial Crisis (Figure 12).

There may also be some form of relief rally in the stocks and sectors that would
potentially have been impacted by some of the nationalisation plans outlined in
the Labour manifesto, such as the UK utilities, BT and Royal Mail.

Finally, we would argue that the wider European equity market may benefit from
more political certainty in the UK and the likelihood of the Withdrawal Agreement
being ratified by the UK Parliament, avoiding a « no-deal » Brexit. We have
previously noted the relatively high correlation between GBP/USD (as a measure of
Brexit risk) and the performance of European assets, such as the Banks and


Domestic stocks: We screen for UK stocks with a high proportion of their
estimated revenues from the UK, that trade at a P/E discount to their European
peers and the broader European market, with positive forecast EPS growth in


GBP Credit – A game of two halves
With the Conservative Party having secured a majority, as per our base case, we

expect GBP credit markets to now trade in line with our 2020 outlook. Our game-
of-two-halves narrative is based on our view that a short-term boost to sentiment

will be driven by clarity on the Brexit front, as the UK leaves the EU by the end-
January 2020 following ratification of the existing Withdrawal Agreement Bill,

which will boost growth in early 2020 and result in further spread tightening
across both GBP IG and HY markets from current levels in H1. We do however
expect the spread tightening to trade in a range short of 2018 tights (IG: 115-
125bp, HY: 390-410bp) given a weaker macro backdrop is likely to persist. In H2,
we expect GBP IG and HY spreads to migrate towards our revised end-2020
targets of 150bp and 585bp respectively (from 133bps and 443bps currently), as
the market prices in both weaker growth and further uncertainty over the
prospects for a finalised EU/UK trade agreement by year end. We also expect credit
conditions to tighten further, supported by the recent decision by Moody’s to cut
its outlook on UK banks to negative from stable at a time when losses due to
default are expected to rise and earnings growth remains negative. That is likely to
force investors to remain defensively positioned, in our view, particularly from a

rating perspective. This should lead to IG outperforming HY over 2020 in risk-
adjusted terms.

From a valuation standpoint, we think current valuations already suggest limited
upside based on the fact that market expectations for a Conservative majority have
already led to both strong absolute and relative performance of GBP credit markets
since October. In absolute terms, based on rolling 12-month Z-scores, both IG and
HY markets are currently 1.s.d. expensive (Figure 17 & Figure 18), supporting our
neutral rather than overweight stance on the asset class in aggregate.


In relative terms however, we do still see signs of value in GBP credit markets
based on a 5-year lookback period in both GBP IG relative to USD IG (Figure 19) as
well as GBP HY relative to EUR HY (Figure 20). In terms of which relative value
opportunity is more attractive, in our view, we think that GBP HY relative to EUR
HY makes more sense to us, particularly in H1, based on our expectation that
fading technicals in the EU HY market coupled with potential spillover risks from
the EUR LL market will put upward pressure on EUR HY spreads.


In terms of fair value for GBP IG and HY spreads, our models currently suggest fair
value spreads at 172bp and 473bp, respectively. The residual today in our view,
particularly on the IG side, reflects supply/demand imbalances in fixed income
markets globally as investors chase higher quality yielding assets given the
divergence between investor yield targets and risk-free rates. Our end-2020 targets
of 155bp and 585bp are based on our view that while growth (proxied by PMIs)
and earnings will improve at the margin (Figure 21) from current contractionary
levels, both tighter credit availability (Figure 22) and a pick-up in HY downgrades
(Figure 23) will continue to put upward pressure on riskier credit funding costs.


In terms of what could cause spreads to tighten further, we look at the sensitivity
of our models to the underlying model variables. It is clear from Figure 24 that
stronger than expected growth, most likely driven by the Labour party’s spending
pledges and/or a meaningful easing of credit availability to both households and
corporates, could lead investors to command less credit risk premium. For IG
specifically, despite debt to EV ratios having risen close to 2011/12 levels, we think
that there will be added importance on earnings going forward in keeping EVs at

current healthy levels, especially against the backdrop of loan growth to the non-
financial corporate sector remaining strong (3.4% vs 1.5% – 5y average). For HY,

which is unsurprisingly more sensitive to ratings downgrades as well as broader
risk sentiment (proxied by the UK sovereign CDS), with UK sovereign CDS already
trading tight at current valuations, we would need to see a growth rebound-led
reduction in downgrade rates and default probabilities.


In terms of how to position, we maintain a preference towards GBP IG over HY for
the full year based on our up in quality bias. Our end-2020 spread targets of
150bp (IG) and 585bp (HY) equate to total returns of 76bp and 49bp and excess
returns of -51bp and -129bp respectively. At a high level, we like owning duration
in higher quality assets and also see value in owning BBB-rated issuers in more
defensive sectors relative to A-rated issuers, where relative valuations are less
attractive and the breakeven on the carry is much lower (i.e. how much spreads
have to move before returns turn negative). From a sector standpoint, we prefer
non-cyclical sectors, given much lower earnings volatility against the backdrop of
heightened uncertainty, and remain neutral on financials.
Given our expectation that dispersion within sectors is set to increase against the
backdrop of weaker growth, we think investors will need to place added
importance on security selection next year. In terms of UK risk within non-GBP
markets and based on the current premium relative to historical tights and June
2016 referendum levels, we like longer dated non-financial UK issuers within EUR
IG and shorter-dated non-financial issuers within USD IG.




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