Markets look to a potential softer Brexit but volatility on the rise

UK election reaction
Our senior investors consider how the UK general election result will impact markets, economies and Brexit.

Mark Burgess - CIO EMEA and Global Head of Equities

Clearly, following the result of the UK general election, the political way forward is difficult. But from a market perspective it's an ambiguous result. What we do know is that markets hate uncertainty and there will be volatility.

So far the strongest reaction has been in sterling, and this will continue to be the case. This has an important translation effect for earnings given the international earnings base of much of the UK equity market, which will benefit from a weaker pound. Remember, the UK stock market is much less reliant on the domestic economy than in previous cycles. A number of stocks that could be vulnerable under a more interventionist government have been weak for some time (such as those in the transport and utilities sectors), so today's result isn't coming from a clear blue sky.

Gilts have managed to retain their 'safe-haven' status through a number of political events in recent years - non-residents accounted for just under a third of demand for UK government bonds in the fourth quarter of 2016 and have been hugely supportive of the market. Any reduction in international investors' appetite for UK assets would constitute a risk to gilt valuations. We don't expect the Bank of England to respond directly to the result but it will be keeping a close eye on consumer confidence, particularly if the decline in the value of sterling extends further from here.

Beyond that, it's hard to draw firm conclusions regarding growth and spending at this point. While they have been reasonably resilient since the referendum, we've seen a definite softening more recently. UK consumer confidence appears to be running out of road and we are likely to see further weakening of the UK economy, which will hit over-leveraged households.

And then we come to Brexit. The election result has reduced the likelihood of a hard Brexit, and this is likely to be economically positive for the UK and Europe. A softer approach to Brexit could, for example, see potential structural support for sterling down the line. It seems reasonable that any Brexit deal will now be subject to greater Parliamentary scrutiny and the government is more likely to seek to retain some elements of single market access.

Confidence in the UK now hinges on how quickly a new government can be formed. With diminished authority it will be difficult for the government to do very much at all and uncertainty is likely to dominate for as long as the position remains unclear.

With no outright winner in the election, it's time for all players to sit down and attempt to achieve a coherent strategy. We need to wait and see what kind of cross-party approach might be viable.

Richard Colwell- Head of UK Equities

Trying to rise above the gloom, clearly the result of the UK election is not what the market expected. But it's worth remembering that the initial market reaction post the EU referendum and US election proved short-lived.

If pressure on sterling continues and the currency returns to the lower end of its recent trading range, dollar earnings for multi-nationals listed in the UK will be boosted. The UK market has been out of favour with international investors for some time. Asset allocation to UK equities is already as low as it was in 2008 at the height of the banking crisis, so there is no sense of hot money leaving the market. The valuation gap with other equity markets, notably the US but also Europe, is as pronounced as it's been for a decade on several metrics.

So lots of uncertainties and the domestic political and economic path forward is murky (and it may well be back to the 1970s for the time being, at least in terms of two elections in one year). However, for UK equities the outlook is more measured and we will be looking for selective buying opportunities.

Adrian Hilton- Head of Global Rates and Currency

The result will be a shock to fixed income markets, which had priced a reasonable Conservative majority into UK asset valuations despite considerable fluctuation in the pre-election opinion polls. Sterling traded lower this morning in reflection of increased levels of political uncertainty. Our own portfolios held neutral positions in both sterling and gilts going into the election.

Uncertainty is likely to dominate for as long as the Prime Minister's position remains unclear, especially since Brexit negotiations are due to begin in less than two weeks. The prospect of a second election is only likely to prolong that uncertainty.

While Brexit wasn't a dominant theme in the election campaign, the issue of Britain's future relationship with the EU could now assume centre-stage. In time, it is possible that financial markets begin to view the election result as a rejection of Theresa May's hawkish approach to the Brexit talks and as reducing the chances of a 'hard' Brexit, especially in light of the Conservatives' likely reliance on the support of the DUP.

Maya Bhandari - Fund Manager, Multi Asset Allocation

There was very little detectable anxiety in markets going into the election, either in volatility or positioning. Sterling, until the exit poll was published, was actually above the level it was when Theresa May first announced the election. Our expectation in the event of a hung parliament was fairly significant weakness in the currency, with bond and equity markets coming under some pressure. What we have actually seen so far, after the initial 2% fall in sterling, is that the currency, while still volatile, has essentially traded sideways. 10-year gilts initially sold off a little, but have come back, as indeed has the curve.

UK equities, particularly large caps, have valued higher although the more domestically-focused mid-caps have sold off. Given recent very subdued levels of volatility across asset classes - not just in the UK but globally - we do expect volatility to increase. Things are more uncertain and greater uncertainty is typically associated with greater volatility, but two developments might limit the rise in volatility. Firstly, the result we had overnight north of the border, which reduces meaningfully the risk of a break up of the UK. Second, the possibility of a Conservative/DUP partnership might soften our stance on Brexit.

Given the higher risk of a hung parliament going into the election we flattened UK risk exposures in our asset allocation portfolios. In our managed funds range, we have a very neutral allocation to UK equities, and in our unconstrained portfolios we have large non-UK exposures. In terms of opportunities, if we did have meaningful weakness in sterling and the UK equity market, that would give us an opportunity to add exposure, given valuations are attractive and about 75% of the FTSE100's revenues come from overseas. But frankly, we are always looking for opportunities and in asset allocation portfolios we have a preference for equities. Within that it has really been in Japan and Europe ex-UK where we have found the clearest and most exciting opportunities.

Important information: This material is for information only and does not constitute an offer or solicitation of an order to buy or sell any securities or other financial instruments, or to provide investment advice or services. The research and analysis included in this document has been produced by Columbia Threadneedle Investments for its own investment management activities, may have been acted upon prior to publication and is made available here incidentally. Any opinions expressed are made as at the date of publication but are subject to change without notice and should not be seen as investment advice. Information obtained from external sources is believed to be reliable but its accuracy or completeness cannot be guaranteed. Issued by Threadneedle Asset Management Limited. Registered in England and Wales, Registered No. 573204, Cannon Place, 78 Cannon Street, London EC4N 6AG, United Kingdom. Authorised and regulated in the UK by the Financial Conduct Authority.