Jeremy Corbyn, Political Risk, and the UK

Chris Brown, Chief Investment Officer

What would happen if Jeremy Corbyn swept to victory in 2020 with a decisive Labour majority? Does April’s revival in UK equities mean markets are more optimistic about a Brexit deal? Here we look at UK political risk and how it might affect our clients’ investment portfolios. Tax rates and house prices also matter to clients’ finances of course (and to me as a UK tax-payer and home-owner). However (tragically), I cannot control these in my seat as CIO of IPS. I can, however, affect clients’ asset allocations and investment portfolios. What to do about UK political risk?

First we need to think whether the issues are UK specific or more global in nature. Rising populism and nationalism leading to more trade wars and heightened global political risk is of course bad for risk assets and investment returns across the board. So far we have seen some of this from Trump’s trade war announcements but this has been offset by investor friendly tax reforms. Net/net the impact has probably been positive. Even for trade tariffs, the bluster and rhetoric has been worse than the actual economic impact so far. We still do not see much of a nationalist trend outside the US, with Brexit the obvious exception. If anything, though, the UK’s Brexit experience so far looks to have pulled the rest of Europe a little closer together. To our eyes political risk is as present as it has ever been in markets but it does not look to be elevated enough to take special caution today.

This is not true though for the UK. Here the landscape (with Brexit and a potentially explicitly socialist labour government on the horizon) looks much riskier than it has done in the recent past. Caution is warranted. But what does caution mean in practice?  We think that the playbook for anything that might be perceived as being (short term) bad news for the UK economy is as follows;

  1. Capital flight from the UK immediately after the shock.
  2. Markets assume the Bank of England will have to cut rates to offset the damage to the economy. Longer term interest rates fall.
  3. Both 1 and 2 lead to a sharp fall in sterling.
  4. FTSE 100 companies see their GBP earnings rise on a weaker pound. As the majority of their earnings come from overseas, UK equities rise as a whole in the short term with gains for global firms offsetting losses for domestic ones.
  5. Investment portfolios gain from their globally exposed UK equities and from falling sterling boosting the value of unhedged international investments. They lose out from the fall in value of UK domestic plays. Overall the effect is positive.

Exactly this mechanism led to gains for sterling based client portfolios for the period around Brexit even though this was a short term, negative shock for the UK economy. Indeed, sterling based portfolios out-performed nearly all non-sterling investment portfolios even though this was a UK specific shock! The reason is the fall in sterling and interest rates more than offset the direct impact of the negative surprise.

To a first approximation, when clients ask us how they would do under a properly left-leaning Labour government this is our answer. It is also how we think markets would react if (very unlikely today) the hard Brexit scenario actually happens. So there is some comfort in remembering that what is bad for the UK economy might be good for your portfolios, in the short term at least.

But life can come at you fast. There is always the risk that last year’s crisis does not look like next year’s. For a Corbyn led government the problem would be an explicit commitment to tax and spend (likely) but where the spending is higher than the tax rises (the route the Trump administration has chosen). This would be inflationary rather than deflationary and the Bank of England might have to counter with higher not lower interest rates. The impact on sterling here is harder to call. Higher rates argue for stronger sterling but short term capital flight might make it weaker. Either way, we would be reluctant to bank on a collapse in sterling to mitigate the impact of the shock.

This scenario is some distance away from becoming reality today but we still need to think about limiting its impact. Our starting point is that the UK is 3.4% of global GDP and 5.9% of global equity markets. As part of our process we have always tried as far as we can not to have too much of a bias to UK equities and UK dependent investments. As an example, emerging markets today are far larger than the UK (China is 16.1% of global GDP all by itself) and remain faster growing. We continue to be as focussed as we has ever been on having as many international investment opportunities as we can. This is a first step to soften the blow of UK specific political risk.

Outside of equity markets, our UK property holdings would also come under review as and when a Labour + inflation scenario looks more likely. Rising inflation should be good for rental growth but rising interest rates will hurt capital values. As interest rates have fallen since 2008, the impact of the fall has been far larger than the slower than normal rental growth we have seen. Property investments have therefore performed strongly. Should this trend reverse and inflation make a return we would expect property values to adjust downwards accordingly. We would therefore be looking at reducing our exposure to this market.

Finally, a comment on the recent Q2 revival for UK equities (which are up 9.4% for the quarter as we type). Whilst it is tempting to ascribe this to increased confidence in UK plc and/or a post-Brexit Britain, in fact we think the recent strength is not all a UK story. Whilst there has certainly been a recovery in beaten up domestic stocks (such as Tesco) as the prospect of a hard Brexit recedes, recent strength has also been oil related. Oil has been stronger on fears that the Iran nuclear deal would be scrapped by the US and on suspicions that the Saudis favour a higher oil price ahead of their Aramco flotation. With Shell and BP comprising 16.5% of the FTSE 100 by themselves, rising and falling oil prices can have a big impact on index returns. Whilst we think higher geopolitical risks around oil are likely here to stay for a while we are reluctant to allocate more to UK equities today for this reason. With no strong view on oil our UK equity allocation looks large enough today to make a difference to client returns but not so large that we pick up too much UK specific risk. We are happy to leave it as it is.

In summary then, for those of you that remain concerned by Brexit and/or Jeremy remember that bad news for the economy often means weaker sterling and lower interest rates. This can limit or indeed take away all of the financial pain. Bad news for UK plc might yet be good news for your investments.