Prime Minister David Cameron led the Tory Party to a UK election victory that was a surprise to pollsters and most observers, including us. The Tory victory removes the risk of a period of policy uncertainty that would have followed an inconclusive election result, which most expected.
This is a short-term plus for markets. Of considerably greater importance for markets are the differences between the Tory Party’s generally market-friendly policies and those of the opposition Labour and Liberal Democrat parties. Cameron pledged not to increase income tax rates, national insurance, or the value-added tax (VAT) during the next parliament. Labour had planned to reintroduce the 50% top income tax rate, to tax expensive “mansions” (which would be a form of wealth tax), to heavily regulate the rental market, and to put a cap on consumer energy prices (a price control). One can question the wisdom or credibility of Cameron’s “five-year tax lock,” but there is little doubt that taxes will be lower under the Tories than would have been the case under the opposition. Fiscal policy over the next five years will also be more austere than would have been the prospect under the opposition, which will be positive for the bond market.
The Tory win means there will be an “in-out” referendum on Britain’s EU membership by 2017. This will result in an element of uncertainty in the medium term for both the UK and Europe. British exit from the EU, “Brexit,” would have negative implications for the UK economy, particularly for the financial sector and the City of London. However, Cameron intends to use the threat of Brexit to pressure the EU for concessions that will help Cameron achieve an “in” vote, keeping the UK in Europe. In a Bloomberg Radio interview yesterday, Alastair Newton, senior political analyst at Nomura International, stated that there currently appears to be a majority in the UK in favor of remaining part of the EU; and although the EU appears likely to agree to only limited concessions, Cameron should be able to sell the case for keeping the UK in the EU.
Another issue in the election was the future of Scotland. The Scottish National Party (SNP) won an unprecedented victory in Scotland, but the Tory win will likely reduce the SNP’s clout in the House of Commons. It would have been stronger under a minority Labour government, with which the SNP had hoped to work. The Tories will work to keep Scotland within the UK. Cameron pledged to:
“… implement as fast as I can the devolution that all parties agreed for Wales, Scotland, and Northern Ireland…. In Scotland, our plans are to create the strongest devolved government anywhere in the world, with important powers over taxation.”
Turning to fundamental economic factors, the UK economy outperformed most of Europe last year with GDP growth of 2.8%. Growth slowed sharply in the first quarter, as was the case across much of the global economy, but the outlook for the full year and for 2016 is for growth to return to close to a 3% annual pace. Economists are expecting an upward revision of the first-quarter data. More recent monthly data indicate accelerating growth after January. In April the Purchasing Managers’ Index (PMI) for manufacturing showed a slowdown in the rates of expansion for production and orders. On the other hand, the PMI for services increased at the fastest rate since last August. This suggests the overall economy is indeed rebounding, as the service sector accounts for some 75% of the UK’s GDP.
Looking forward, a pickup in wage growth, coupled with very low inflation, implies a strengthening of household spending power that will lead to increased growth in consumer spending. Also, business investment intentions are favorable, based on strong profitability and robust corporate finances. Export growth has picked up and should continue to strengthen.
The reduction in investor uncertainty following the election, coupled with the positive economic prospects, should strengthen the outlook for UK equities. The largest ETF for the UK equity market listed in the US is the iShares MSCI United Kingdom ETF (ARCA:EWU). Up to May 7th, EWU had gained 5.27%, somewhat below the 7.97% advance of the benchmark iShares MSCI ACWI ex-US Index Fund (NASDAQ:ACWX). But over the past month, EWU’s 2.1% increase was considerably better than the 0.37 advance for ACWX.
Friday, EWU bounced up some 3.5%, most likely reflecting both the immediate reaction to election results and global market improvements. We will be closely monitoring the market’s follow-through in the next several weeks.