Brad here. One of the big political and economic news stories in the past week or so has been the British election. Here to help put that election into context—and think about what it could mean for our investments—is Anu Gaggar, Commonwealth’s international analyst. Thanks, Anu!
Three and a half years ago, Britons voted to exit from the EU (known as Brexit). Last week, they voted to bring to power a government that has promised that their Brexit wishes will be granted. These snap general elections in the U.K. resulted in a sweeping victory for the incumbent ruling party, the Conservatives (i.e., Tories), led by Prime Minister Boris Johnson, as well as a catastrophic loss for the Labour Party, led by Jeremy Corbyn. The markets were quite pleased with the election outcome. Nonetheless, Britain’s departure from the EU is far from a reality.
The Brexit withdrawal bill
The Tory victory crushed all hopes of a second Brexit referendum, which the Labour Party had hoped would prove that the first referendum of three and a half years ago was an aberration. Instead, the British voters reaffirmed their desire to leave the EU. Further, the election results have awarded Prime Minister Johnson with a strong mandate to push his agenda, of which the Brexit withdrawal bill is a primary component. The bill is expected to be passed in the British Parliament on January 31, paving the way for the U.K. to finally leave the EU. Thus, the election has reduced some near-term geopolitical uncertainty—uncertainty of a second referendum and of Britain stumbling out of the EU without a deal.
What happens next?
If the withdrawal bill passes, will the U.K. and EU go their separate ways? Will trade continue between them? If yes, on what terms? Britain and the EU will be working to answer these questions between the passing of the bill and the end of 2020. There is also the possibility that the transition period will be extended even further, especially if the negotiations do not show much progress. Given how long it took to get to this point since the first referendum, extension of the transition period is a real risk. The Brexit saga is not quite over.
The election results are likely to embolden Prime Minister Johnson to push the Conservative Manifesto. Among other things, this manifesto includes opening the fiscal spigots. With interest rates at historic lows, borrowing to spend on infrastructure, schools, scientific research, and clean energy solutions is likely to be a palatable idea.
What about the markets?
Capital markets, particularly U.K. equities, have been one of the primary beneficiaries of the elections. As investors, we dislike uncertainty because it is hard to wrap our heads around. But with the snap elections behind us, one layer of uncertainty has been removed. This shift was applauded by the equity, bond, and currency markets. Year-to-date, the broad FTSE 250 Index (the British Main Street index consisting predominantly of domestic-oriented British companies) is up more than 25 percent on the prospect of Brexit moving forward.
Ironically, the same index crashed nearly 14 percent after the Brexit referendum. So, why did London’s Main Street index go down then but is up now? At the start, markets grew anxious when they were plunged into the divorce proceedings after the Brexit referendum, with no precedents to look to. Three and a half years in, the markets are now anxious to see the finale of this saga and to move on to business as usual. Or perhaps the markets are simply relieved that the Labour Party lost the elections. Although the Labour Party would likely have negotiated a softer Brexit deal or attempted to reverse it altogether by holding a second referendum, its other policy proposals—like raising corporate taxes and nationalizing certain industries—were seen as quite business unfriendly.
Heading into 2020, risk-sensitive areas of U.K. equities could benefit from lower political uncertainty, expansionary fiscal policies, and a rerating of economic growth. These areas may include domestically oriented U.K. equities, small-caps, home builders, and domestic banks. Clarity on the terms of trade post-Brexit could also unlock pent-up business investments. If global growth bottoms, it could provide a ballast to exports. Exports account for 30 percent of the U.K.’s GDP; hence, a recovery in exports could translate into better GDP growth. The positive 2019 could lead to a positive 2020.
Brexit: The final season?
But we are not done yet. Remember, the recent elections have reduced but not eliminated uncertainty. As noted earlier, if the withdrawal bill passes, the U.K. will enter a transition period, which could be protracted. There is much to be negotiated in the next several months (or years): trade, movement of capital and labor, intelligence sharing, and, of course, the Irish border. Plus, there is always the risk that the EU and U.K. revert to World Trade Organization rules if they cannot arrive at a mutual agreement, leading to a hard Brexit after all. These uncertainties could put a lid on the rebound in GDP growth. For investors, this could be a long final season of the Brexit saga.