UK Election May Boost ETFs

Shanny Basar

BlackRock said the result of the UK election may increase fund flow activity in UK equity exchange-traded products due to potential sterling weakness and the possible impact on large versus small UK companies.

The UK general election yesterday resulted in a hung parliament, with no party winning an overall majority, despite expectations that the governing Conservative party would increase its narrow majority. This will affect the negotiations on Britain’s exit from the European Union, which have to end by March 30 2019 unless all 27 remaining EU states agree an extension.

BlackRock’s ETF business, iShares, said the result is a mild short-term negative for UK domestic assets due to the uncertainty and prospect of a weak government vulnerable to losing votes in parliament. There is a a bigger risk of an economically disruptive ‘no deal’ Brexit  but also a wider range of potential outcomes, including a softer Brexit.

“The pound should remain a good barometer of Brexit risks,” added iSshares. “We see the election outcome as primarily a UK domestic issue and do not expect broader ramifications for global markets but do see potential implications for domestically sensitive UK companies.”

The note continued that a hung parliament may increase fund flow activity in UK equity exchange-traded products. “Given potential sterling weakness and the possible impact on large versus small UK companies, dimensions investors may want to consider include currency hedging and market capitalization,” said iShares.

Until 19 May UK equity ETPs had  attracted $1bn this year,the biggest net flow into any European country ETP over the period but between 19 and 26 May, $500m flowed out ahead of the general election. “This data suggests increasing agreement across investors that country ETPs can be a precise way to gain exposure to political and economic outcomes,” added iShares.

Mike Amey,  Pimco’s head of sterling portfolio management, said the result shows voters are becoming tired of relentless austerity and rejected leaving the Brexit negotiations to a small, somewhat secretive group who would decide the UK’s future relationship with Europe. “This suggests that for the electorate to be satisfied with their elected politicians, we should see easier fiscal policy and a lower risk of a disruptive or “hard” Brexit,” he added.

Amey continued that faced with this uncertainty, the immediate response of a modest sell-off in the pound, a steepening of the UK yield curve and slightly lower bond yields seems fairly reasonable.

“Looking ahead, assuming a base case of easier fiscal policy and a “softer” Brexit, we would expect higher yields, a steeper yield curve and stability returning to the pound,” said Amey. “However, given the many risks to this view, we suggest investors remain cautious. It may well be the case that British politics proceeds smoothly, but as we know, it has a habit of throwing up unexpected outcomes.”

David Zahn, head of European fixed income and portfolio manager at Franklin Templeton Fixed Income Group, said the firm expects the pound to plummet and gilt yields to decline as investors embark on a so-called flight to safety. “Overall, we think so-called risky assets, such as equities, are likely to underperform,” added Zahn.

Flanders, part of the global markets insights strategy team, said sterling pound fell nearly 2% against the dollar overnight and currency weakness has generally supported the main equity index over the past year.

However, UK equities could continue to underperform the other major developed markets, especially the eurozone,” she added. “The MSCI Eurozone Index has risen nearly 20% since the start of the year, roughly twice as much as the FTSE All Share in dollar terms.”

She continued that the UK was one of few economies to see its growth forecast cut in the latest estimates from the OECD. “The same report also showed it to be the only major developed economy that will significantly tighten fiscal policy over the next two years. Politically and economically, it sticks out like a sore thumb,” said Flanders.

Saker Nusseibeh, chief executive of Hermes Investment Management, said the expected reaction is for both sterling to come down and possibly the FTSE, notwithstanding sterling’s fall. “We are likely to also see forward markets discounting rises in interest rates which will adversely impact the consumer in the short term as mortgage rates could start to rise further and faster than most borrowers budgeted for,” added Nusseibeh.

Aberdeen Asset Management said the result potentially intensifies the downside risks to the near term economic outlook via sentiment and confidence. The fund manager added: “That said, just as markets have become used to political shocks and uncertainties over the past 12 months, UK firms and households have shown a remarkable degree of resilience, too. And Bank of England Governor Mark Carney has shown his willingness to maintain monetary policy accommodation in the face of such uncertainty.”

Darren Williams, chief economist, said: “In our view, there probably won’t be a significant near-term economic impact. However, the success of Labour’s anti-austerity message is likely to lead to a looser fiscal policy over time. This, plus increased political uncertainty – including the risk of a second election at which the Labour Party might do even better – will probably weigh on the gilt market.”

Williams added that the pound looks most vulnerable. “The one positive for sterling is that its downside is probably limited by hopes that last night’s fiasco will ultimately lead to a softer Brexit,” he said.

James Butterfill, head of research & investment strategy at ETF Securities, said a potential rate hike in second half of the year now looks less likely and the  result is broadly inconsequential of European equities

“One saving grace for the UK is the Conservative gains in Scotland highlighting an independence referendum now off the table, putting to bed the risks for a UK breakup,” he added.

Azad Zangana, senior European economist at Schroders, told Morningstar there is now a higher risk of inflation, and additional borrowing, which may mean higher gilt yields.

“There is also the added worry that if the economic slowdown becomes a recession the Bank of England is out of ammunition; rates cannot go any lower and quantitative easing has little impact in stimulating the economy,” added Zangana. “Fiscal policy – cutting taxes – is all that is left, but getting any such measure through parliament will be a nightmare, you need a strong government to get through difficult times.”

Dr. Brian Jacobsen, chief portfolio strategist, said: “There’s a popular idea that markets hate uncertainty. That’s just false. Markets have thrived on uncertainty.”

He continued that if Prime Minister Theresa May had received an overwhelming majority, it was likely that would have pushed for a tougher negotiating tack with the EU.

“A softer Brexit could be positive for the long-term—for Europe and the UK—even if the initial market reaction was that the pound dropped nearly 2% on the early news,” added Jacobsen.

Miles Celic, chief executive of lobbying group TheCityUK, said: “With the imminent Brexit negotiations, it is vital that we prioritise clarity around the UK’s approach and maintain a sharp focus on getting the best possible deal. We have been working hard to detail what this looks like, and today’s result does not change the core issues that need agreement.”

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