How To Protect Your Portfolio In The UK Election

As a global investor, we’ve been keenly focused on the UK general election and its potential impact on financial markets for some time. This election is likely to be one of the closest fought in recent memory, and it has become increasingly difficult for investors to predict a clear result come 7 May.

Uncertainty Reigns

The shift away from the two major parties of Labour and the Conservatives towards challengers such as the Scottish Nationalist Party (SNP) means there is now a strong likelihood that no single party will gain enough seats to rule as a majority. This leads to uncertainty for a number of reasons: the expectation of a hung parliament and the potential for a protracted period of negotiations between parties; the myriad of possibilities for allegiances between parties; and the sustainability of any agreements over the longer term in light of the Fixed-Term Parliaments Act (2011).

Coalition Means Risks For Investors

It is now highly likely we’ll see a minority or minority coalition government in place post-election, and there is no outcome here that is without risk for UK assets or sterling. So, investors are considering whether a Conservative-led coalition means a higher probability of an exit from the European Union, and whether a Labour-SNP coalition could result in another Scottish independence referendum and a sharp rise in government spending.

Any coalition agreement will mean that compromises need to be made, and the ability of any minority government to rule effectively and efficiently would be vastly reduced when each piece of legislation needs careful negotiation in order to gain support. The uncertainty this presents, combined with the extended time period of political paralysis it may take to form a government, serves to fuel speculation and nervousness in financial markets.

Taking Nordic Protection

Here at Nutmeg, we’ve taken action to protect our customers’ portfolios from risks that we believe may lie ahead as a result of the election. We’ve reduced our UK FTSE 100 investments, still holding some UK stocks but typically one third of what we would normally hold in a Nutmeg portfolio. We haven't completely removed UK equities from portfolios because a weakness in sterling against the dollar may prove useful, such as providing a boost to international earnings and increased mergers and acquisitions activity.

In wider equities, we have identified better prospects outside the UK – in Europe, the Nordics and Japan. The Nordics give investment exposure that is similar to the UK, without the idiosyncratic election risk. There is strong economic growth there too; a good hedge versus the UK market along with very supportive monetary policy.

Stocks in continental Europe also provide greater exposure to improving economic prospects because of the European Central Bank’s emergency quantitative easing (QE). Japan is another country whose central bank is going all-out to turn the economy around with a very supportive monetary policy and potential for more QE.

Deterring Foreign Investment

The UK election may be dismissed as a blip from a long-term perspective, but the move away from the traditional two-party state could have significant permanent ramifications for how the UK is governed and perceived abroad. The UK is the world's third largest stock market but overseas investors have many markets to choose from; U.S. investors sold $58 billion of UK equities in the lead up to the Scottish independence vote. More recently, U.S. investors have added to holdings over the past month via ETFs.

More broadly, there is very little indication that these risks are yet to be factored into investment markets. Option markets suggest there is little additional risk in sterling and short positioning has been reduced significantly compared to the start of the year. In equity markets, we find scant evidence of investors preparing for the possibility of higher risk in UK stocks.

Turning Bond Sentiment

Sentiment in bond markets does however appear to be turning.  In the lead up to previous elections, overseas investors have been happy to buy gilts, but so far in 2015 foreign investors have sold £14 billion of government bonds. Moreover, auction results have been poor, suggesting a buyers strike [refusing to purchase more bonds].  Nevertheless, gilt yields are still 0.25 percent below U.S. yields, which does reflect the risk to the UK fiscal position.

We think international investors are likely to reduce their holdings of UK stocks in the coming months and many will be worried the pound is going to see significant weakness as uncertainty rises over the election period.

Ultimately, we are always looking to manage the risks we take in our customers’ funds, to not take too much risk and consider the range of possible outcomes so we can react when we need to.

Shaun Port is chief investment officer at Nutmeg