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A coalition government and trading around events

02 June 2017

Last week’s CIO Question Time looked at the impact of a Tory victory but what happens to markets if they fail to win?

When Mrs May called an election with a 20 point lead in many polls, this question seemed almost irrelevant. As the campaign has progressed, the polls have narrowed with one opinion poll company indicating that the Tories could end up losing their majority in parliament. If this happens, Mrs May will be seen as a disastrous party leader and there will be doubts about her position even if she manages to pull a coalition together. Should the Tories not win, a Labour majority still seems farfetched and some form of coalition would probably be the outcome; thus the Scottish Nationalists and Liberal Democrats may hold the balance of power. Whoever they ally themselves with, they will both be looking for either a soft Brexit or a second referendum on the subject. The SNP will also be looking for a second referendum on independence. In either case, coalition politics will make the stance in Brexit negotiations harder to agree.

The pound was the chief beneficiary when the election was called and has fallen back recently as the Tory lead has declined. The prospects of a soft Brexit, or the chance of no Brexit if another referendum was called, could be positive for the currency. However, a weak government with less spending controls could also be seen as a currency negative. On balance, my conjecture would be to expect a similar reaction to the way the market reacted to the polls which saw the pound fall in the event of a hung parliament. A falling pound usually would benefit the UK equity market as a whole, however companies where Labour propose nationalising industries and companies with less overseas exposure could be adversely affected. The Gilt market will be a balance between a flight to safety and longer term concerns over government credibility and possible increased supply. Index linked Gilts may outperform as inflation expectations move up but rate rises move further away.

My belief is that May will win in June and I would not expect big moves should this happen. Markets move more on the unexpected rather than the expected, so it is wise to consider this in our scenario analysis.

Should we try and trade around events?

As noted above, events can impact markets and some people want to trade around political events and announcements of economic numbers. This can be a dangerous game to play. Often markets react in ways you do not expect and as aforementioned, the biggest reactions tend to come from the most unpredictable events. Looking at, for example, both the Brexit vote and Trump’s election last year, there were dire predictions about market reaction to the outcome. In the end, sterling weakness boosted UK stock prices and Trump’s expansionary policies outweighed the uncertainty around a maverick president. In the case of Brexit, the knee jerk reaction was for the FTSE index to sell off very sharply but it recovered swiftly.

Taking short term trades in the face of events can lead to mistakes. It is usually better to stand back and take time to consider the longer term impact, only then should we adjust our positions to a changing environment. There will be a flurry of comments on Friday morning next week as the result of the election becomes clear but we need to remember that today we exist in a global world and domestic politics may be outweighed by events elsewhere.


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