Following the surprisingly decisive U.K. election results, Morgan Stanley analysts anticipate continued tight fiscal policy, while UBS analysts believe the results will be positive for U.K. equities.
Jacob Nell and team at Morgan Stanley said in their May 8 research report titled “UK Economics and Strategy: General Election” that, thanks to a pick-up in supply over the next six months, gilt yield should rise.
U.K. Election results mean tight fiscal policy will continue
Following the U.K. election results, the Morgan Stanley analysts expect continued tight fiscal policy with a step-up in austerity in 2016/17 and, in particular, an in/out referendum on the U.K.’s membership in the EU with accompanying uncertainty for investors and a continuation of the current broadly pro-business policies. The analysts continue to see an EU exit as much more than a tail risk, though not their central case. They note that SNP has managed to make an almost clean sweep in Scotland. Partly in response to the SNP dominance of Scotland, the analysts anticipate a new fiscal settlement in the U.K.
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Turning their focus on a rates strategy, the Morgan Stanley analysts note that a Conservative-led government will likely be seen as the most fiscally austere party, and hence, asset swap spreads should enrich investors. They believe fiscal austerity will be front-loaded in 2016 and 2017, thereby delaying possible bank rate hikes and benefiting red/green short Sterling contracts.
Focusing on a near-term GBP rebound, Jacob Nell and team at Morgan Stanley expect the initial GBP rebound to be more emphasized than initially assumed. They note that GBP/USD has already pushed higher towards the upper end of the recent range at 1.55, just ahead of the key level at 1.555, which they consider as pivotal for the near-term outlook. They believe a move above here will trigger some further near-term gains towards the 1.5825 area.
However, the Morgan Stanley analysts point out that longer-term risk factors remain. They note that the prospect of fiscal tightening and a continued dovish BoE could take some steam out of sterling gains. They point out that the prospect of an EU in/out referendum should also weigh in the longer term.
Sterling to maintain momentum – UBS
In their May 8 research report titled “The UK Election: Implications,” David Tinsley and team at UBS note that sterling is the clear outperformer on the day in the wake of the initial election results. They add that the reaction in the options market was strong as the one-week implied volatility has collapsed and the skew toward near-term expiries has also normalized.
The analysts point out that considering the U.K.’s well-documented exigent economic outperformance, sterling stands to maintain momentum. However, the analysts would prefer to avoid chasing GBP strength versus EUR and USD aggressively and favor relative value trades against non-majors.
As regards to the longer-term, the UBS analysts hold the view that the term premium should remain elevated or even rise further for the currency. The analysts point out that, barring a highly unlikely abandonment of one of the Party’s key pre-election commitments, an EU referendum will be key by the end of 2017.
David Tinsley and team note that there is an absolute consensus that an EU-exit for the U.K. would require a material re-rating of the currency and its fair value. They point out that the cost of at-the-month GBPUSD puts expiring at the end of September 2017 has dropped to the lowest level of 2015, and they believe this is a clear mis-pricing, given the importance of the decision.
Turning their focus towards equities, the UBS analysts believe the Conservative Party’s victory will be positive for the U.K. equity market as many of the specific sectors in which there were Labor policies that were perceived to be potentially negative may well have a relief rally – such as Banks, Utilities and parts of Transport.