Our political stance and approach
As is the case with all of our commentary around such events, as a company we cannot and do not take a political stance. Rather, we take a view on how markets are likely to interpret and react to events, in order to formulate our investment thesis.
The nature of politics is such that it is extremely difficult to make quantitative predictions based on hard metrics. As a result, for much of this article we limit our assessment to direction and broad magnitude of the various factors favouring accuracy over precision, and aim to provide you with some insight into our investment thinking.
Jeremy Corbyn is well-known for favouring some fairly radical left wing policies, some of which would almost certainly be a huge shock to the market. For example, “People’s QE” – which effectively forces the Bank of England to directly fund infrastructure spending.
However, leadership requires a certain amount of compromise with the wider party – and whilst a Corbyn-led Labour government would likely be further to the left than other recent Labour governments, it seems a safe assumption that most policies will be more mainstream.
This is evidenced by the Labour Manifesto for the summer 2017 election, and we will use this as the basis for short-and medium-term investment impacts, although we acknowledge there would be a risk of more radical policies coming through further down the line. There is also an open question on Brexit policy under Jeremy Corbyn, who is known to be personally sceptical on the EU, whilst the rest of the Parliamentary Labour Party is generally pro-EU.
What’s in the Labour manifesto?
As one might have expected, the manifesto was heavily redistributive, with increased taxes on corporations and the wealthy coupled with improved pay for lower-paid workers and fresh infrastructure spending. Taking this manifesto as a fair representation of what a Corbyn Premiership would give us, the big ticket items from an economic standpoint are:
- Higher Income Tax, with the 45% rate threshold brought down from £150,000 to £80,000 and re-introduction of the 50% tax rate above £123,000
- Increase headline Corporation Tax to 26% with a lower rate for small businesses
- Increase the minimum wage to above £10 per hour and remove the public sector pay cap
- Re-nationalise utilities, Royal Mail and the railways
- Significant infrastructure spending aimed at upgrading the economy
Expectations: economy vs the market
We often highlight that capital markets are not the same as the economy, and this is especially true when it comes to implications of political policy. Labour’s policies are certainly less business-friendly than Conservative policies, but it does not necessarily follow that such policies are bad for the economy.
At the risk of excessively over-simplifying, the competing economic policies in the current environment run as follows. The Conservatives favour growing the economy by incentivising business investment and employment growth whilst controlling borrowing to minimise the debt drag. Conversely, Labour economic policy favours government investment through higher borrowing today, enabling relative debt to fall amidst faster economic growth (and therefore higher tax revenues) as well as greater consumption driven by higher wages.
To our minds, neither is definitively right or wrong in the long term, but they come with their own specific challenges. In particular for Labour, there are key risks around the disincentivisation of businesses to make investment and the increase in debt, which has already contributed to the UK’s credit rating being downgraded. These would need to be offset by improved productivity, higher taxes and increased consumption. In this regard, we do see elevated risk to the near-term economic outlook, where the evidence we look at suggests the consumer is tapped out and the economy needs investment spending to pick up the slack.
The case for markets is much clearer though. A Labour government is unambiguously bad for capital markets, as it presages the rebalancing of rewards for economic growth away from capital and back towards labour. Despite solid economic growth, post-Global Financial Crisis (GFC) the spoils have disproportionately favoured capital and the owners of that capital – essentially equity markets via corporate earnings.
At the same time, as the chart below shows, real (inflation-adjusted) wages remain lower than they were prior to the GFC. Indeed, as we have spoken about over the last couple of years, a differential between returns to human capital (wages) and financial assets (investments) has driven a perception of social and wealth inequality which has helped fuel recent populist movements – a global shift, with many examples.
Cumulative growth of UK GDP and real wages
To better assess the impact on the investment landscape, we should consider the tangible impact that the anticipated policies would have on the outlook for the key factors of fiscal policy, monetary policy and corporate earnings.
Much expanded fiscal stimulus on infrastructure as well as public sector pay will see the deficit widen significantly. Based on the 2017 election assessment, the Institute for Fiscal Studies estimates borrowing will be £37 billion per year higher in 2021-22 under Labour (£58 billion deficit) compared to the Conservatives (£21 billion deficit).
The Bank of England will likely look to tighten monetary policy more aggressively under a Corbyn-led Government, in anticipation of higher inflation caused by fiscal stimulus and government-mandated wage increases (via increasing the minimum wage and ending the public sector pay caps).
Stimulus measures may help top-line sales over the medium term, whilst a depreciating currency would flatter the overseas revenues that account for three-quarters of the earnings for UK large-caps.
However, these benefits would almost certainly be outweighed by the negative effects, both direct and indirect. Firstly, the increase in Corporation Tax would directly and almost immediately hit corporate earnings, and would be the single biggest impact, being factored mechanically into analyst models. Higher employment costs would further erode margins for those firms employing large numbers of workers on the minimum wage, as would the increased borrowing costs resulting from tighter monetary policy.
The impact on asset classes
From the impact that a Corbyn-led Government would have on the fundamental backdrop, we can assess the likely effect on core assets classes from a UK investor point of view.
UK equities – negative
The triple negative of increased taxation, wages and borrowing costs would likely have a fairly immediate impact on UK equities from an earnings outlook perspective and could trigger a de-rating of valuations.
UK government bonds – negative
The prospect of a significant increase in the fiscal deficit is unlikely to be welcomed by the bond markets, whilst a more aggressive Bank of England could give rise to a rout in gilts.
Gold – positive
Whilst the yellow metal effectively has minimal intrinsic value, its use as a store of wealth means it can act as a form of insurance against serious geopolitical events. Furthermore, even if Jeremy Corbyn’s ascent is not considered a particularly major event globally, the fact that gold is priced in US dollars means that sterling-based investors would still likely benefit from currency effects.
Overseas assets – positive
With the change of government being a localised affair, the broad impact on global assets is likely to be minimal. However, the UK’s twin deficit (trade deficit and public sector deficit), and a negative outlook for sterling assets covered above, means the currency will probably be the first casualty, even after giving consideration to a potentially softer Brexit position and higher interest rates.
This would provide an uplift for overseas assets held in their native currencies as sterling investors benefit from translational effects. We can infer some evidence of this from the snap election called over the summer. The chart below shows Labour’s polling success (blue line, left hand scale) compared to sterling (purple line, right hand scale, inverted). It is clear from this chart that markets were pricing in an increasingly negative currency outlook as the probability of a Labour victory increased.
UK snap election June 2017 – Labour polling versus trade-weighted sterling
Politics has been a big focus for markets recently. Over the last couple of years one of our investment themes has been ‘The Politics of the Disenfranchised’. This theme has focused on the perception of social and wealth inequality driven by falling real wages (and therefore living standards) whilst those with financial assets have benefited from rising markets. Across the world, this has given rise to populists and anti-establishment political movements. In the UK, even supporters of Mr Corbyn agree he is an anti-establishment candidate, and his recent groundswell of support has cemented him as a serious contender for power.
When it comes to investments, however, it usually pays to take a more measured and evidence-based approach. Investing should be a global activity, and from that point of view UK politics is something of a storm in a teacup, despite the column inches dedicated to it locally.
Furthermore, a Prime Minister Corbyn scenario is still a very long way from the base case. Whilst bookies have him as the favourite for next Prime Minster, with 5 to 1 odds at the time of writing, this more reflects the fractious state of the Conservative party. If you aggregate the data, the likelihood of the next Prime Minister being Conservative is about 80%. Despite the terrible result over the summer – or perhaps because of it – there is a strong incentive for the Conservatives to prevent a collapse of their own government that could come with a messy leadership challenge.
As a result, whilst we continue to monitor the political landscape closely, we are cognisant of the costs and risks of overreacting to high-impact, low-probability events – which typify many political (and geopolitical) events.
Often the best approach to mitigate these risks in a portfolio is through diversification, and we do this by holding a range of asset classes and being globally diversified. In this way, portfolios can benefit from broad movements in asset prices, whilst limiting the impact from small, isolated events.
The likelihood of Jeremy Corbyn leading the country has increased significantly throughout this year, but in reality it still remains very unlikely. Were he to take power, however, the impact on sterling assets would be decidedly negative, with UK equities, gilts and sterling all likely to fall in the short term as markets price in policies designed to rebalance the share of economic gains from capital back to labour.
As a result, we view this scenario as high impact, low probability, and we mitigate against adverse outcomes in our investment strategy by remaining globally diversified and including positions, where appropriate, in physical gold as a specific hedge against geopolitical risk.
This article was previously published on Tilney prior to the launch of Evelyn Partners.