The stock market reaction to the unexpectedly decisive Conservative victory in last week’s election was more significant than it looked. While a near-2% rise in the FTSE 100 was welcome, it disguised what was going on beneath the surface. You needed to lift the lid on the more domestically-focused FTSE 250 to understand the scale of the relief rally that was lifting all boats on Friday.
In the morning-after euphoria that gripped the London market, I was struggling to find any real companies in negative territory. The only fallers were internationally-focused investment trusts for which the UK election was an irrelevance. The rest of the mid-cap index was enjoying one of those glorious days when to stand a hope of getting on the leader-board you needed to be up 8,9 or 10% on the day.
Banks, builders and bus companies alike were posting double-digit gains. Construction companies, storage businesses, even unfancied bricks and mortar retailers were not far behind. When Marks & Spencer is up 8% in a session, you know something significant is happening. For UK investors, who have got used to being the pariahs of the global investment scene in the years since the EU referendum, this was a champagne moment.
As the old market adage has it, however, even dead cats bounce a bit when dropped from a great enough height. So, does the Brexit rebound have legs? To answer that, you need to look at first the politics, then the economics and finally the market fundamentals.
The politics changed out of all recognition at 10pm last Thursday night. The moment the exit poll pointed to the best result for the Conservatives since Margaret Thatcher’s pomp, it was clear that the Brexit arithmetic had shifted irrevocably. With a meaningful majority, not only will the Withdrawal Agreement pass in time for Brexit by the end of January, the self-imposed constraint of no extension to the December 2020 trade-deal deadline becomes an irrelevance.
Until the election, investors quite rightly fretted that achieving a satisfactory trade deal in eleven months was impossible. Now it doesn’t matter because an extension, which by the way does not need Parliamentary approval, will become a shoo-in in the middle of next year. Having delivered Brexit, and put in place a points system to manage immigration, no-one’s going to quibble about pushing the deadline out to the end of 2022. Even if they do, they won’t be able to do anything about it.
The rising probability of a more-aligned, softer Brexit now the majority is in the bag, and the real Boris can emerge, is cat-nip to investors.
When it comes to the economics, the election also changed the calculus last week. Credit Suisse reckons the consensus growth expectation for the UK economy of about 1% in 2020 will turn out closer to 1.5% for a bunch of reasons.
First, spending commitments are expected to add about 0.7% to GDP. The demolition of the ‘red wall’ of safe Labour seats across the North of England and Wales was partly about Brexit. To an equal extent, however, it was a consequence of spending promises that Boris Johnson must honour if he is to prevent the one-off loan of Labour Leave votes being abruptly called back at the next election. Fiscal stimulus is the quid pro quo of the populist contract with a new set of voters that changed the habit of a lifetime through gritted teeth.
Second, wage growth is rising at close to 2%, having been falling at the start of last year. Exports to a recovering Europe will make a decent contribution too. Businesses should start drawing down inventories as activity increases. And investment is forecast to pick up, as the twin threats of a No Deal Brexit and an anti-business Labour Government are taken off the table.
Which brings us to the investment fundamentals. It’s not hard to see why the UK stock market should have been sold off as aggressively as it was in the run up to the election. The threat, however remote, of a Labour government - nationalisations, higher taxes, regulation, ‘inclusive ownership fund’ and all - had understandably built in a risk premium. Those risks have gone for the foreseeable future. Indeed the scale of Labour’s defeat makes a recovery in five years’ time look a long shot. The 2020s are the Conservatives’ to lose.
Years out in the cold have left UK shares cheap compared to what an investor might expect given a range of factors like the exchange rate and the oil price. On this basis, they are probably 24% below fair value. This is also true on the basis of traditional comparisons with earnings, asset values and dividends. Until very recently, funds were also flowing out of UK equity funds and had been for several years.
So, the politics, economics and fundamentals argue for getting back into the UK market. Having made that decision, where should you look for the best opportunities?
Well, the top risers on Friday are not a bad starting point. Domestic stocks - banks, transport companies, pubs, leisure companies - dominated the leader-board for good reason. Home-grown businesses are unfairly cheap when you consider that they stand to be the greatest beneficiaries of increased infrastructure spending, rising bond yields and improving consumer sentiment.
Smaller companies have also underperformed the bigger stocks and should bounce back if strengthening sterling makes the big exporters less competitive and their overseas earnings less valuable on translation.
Areas to be nervous: be careful with housebuilders, where valuations are in some cases punchy; retailers - victims of unstoppable competitive forces; and property companies in areas like retail and financial services, where demand for space is falling.
The UK is not out of the woods yet, but that’s good news for investors. If all our local problems had disappeared last week, so too would the investment opportunities.
Important information: The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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