Stock Traders Prepare Game Plan for Biggest Shakeup Since Brexit

(Bloomberg) -- The earlier-than-expected UK election is prompting traders to prepare for the country’s biggest political shakeup since Brexit, despite the mostly muted market reaction since the announcement was made.

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Market strategists are gaming out election scenarios, with history showing UK equities trading relatively flat, or lower, during the first six months after wins for the ruling Conservatives. By contrast, stocks have historically strengthened about 6% following victories by the poll-leading Labour party, according to Citigroup Inc. strategists led by Beata Manthey.

“The FTSE 250 has tended to outperform the FTSE 100 following elections, with stronger outperformance following Labour victories,” she said. “A mix of defensives and financials have tended to fare best post-election.”

The winner of the July 4 ballot will have limited fiscal headroom and face scrutiny from bond vigilantes — as the short stint of Liz Truss as prime minister showed.

Utilities took a beating after the election date announcement on Wednesday, while homebuilders saw a spike in volatility. Defense spending and sale of government stakes could be up for debate, while the status of proposed M&A — such as the situation with Royal Mail-owner International Distribution Services Plc — could be up in jeopardy.

Elections are often a source of volatility, but political instability since the Brexit referendum has been particularly acute in the UK. Having the general election sooner may help remove this uncertainty, according to Barclays Plc. strategists led by Emmanuel Cau.

In particular, the pound has been hit and never fully recovered since Britain voted to leave the EU. Still, potentially closer ties with the bloc under a Labour cabinet could help narrow the pound’s so-called Brexit premium, which has kept the currency in check over the past eight years, the strategists said.

“The potential prospect of a somewhat more stable government may be something of a medium-term positive compared with the political division that’s been prevalent post-Brexit,” Cau’s team said. “An unwind of the Brexit premium could lift the pound and favor domestic plays and FTSE 250, over exporters and FTSE 100.”

For Cau and his team, the snap election announced could further boost sentiment for recently rallying UK stocks. They like parts of the market that are sensitive to growth and interest-rate cuts, such as banks, housebuilders, retail, leisure, real estate and utilities.

The UK remains one of the cheapest developed markets, while being among the most fertile ground for high dividends, buybacks and M&A.

Still, the stock market isn’t just swayed by politics and its outlook is heavily dependent on monetary policy as well as the economy.

Recent inflation data disappointed those who were expecting a rate cut from the Bank of England as soon as in June. The likelihood of that fell to less than 10% currently, from more than 60% about a week ago, while an August cut has become a coin-flip.

Read more: Pound Gets Boost as UK Vote Nixes Holdout Bets on June Rate Cut

That could also be a tailwind for the pound in the near term, reducing the period of monetary policy divergence between the Bank of England and the Federal Reserve, which is not expected to cut rates before September. By contrast, the European Central Bank is seen reducing rates next month.

Overall, even as budget constraints will force policy consistency between the major parties, the election could create a political imperative to increase investment, liquidity and participation in UK markets after years of relentless outflows, according to Jefferies analysts including Mark Braley.

For all of the UK’s challenges, its markets are arguably “better positioned” than they have been for years with “cheap valuations, a likely fast rebound from a fleeting recession, lower policy volatility and a regulatory tailwind,” they said.

--With assistance from James Cone and Joe Easton.

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