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Corbyn: The investment silver lining?

Posted by: Brian Dennehy
Membership level: Free
The betting is 1/3 that there will be a General Election in 2019 – in other words, highly likely.  How might markets respond short term and longer term? Particularly if there is a change of Government, and knowing that markets hate change.
 
I will come to the possible impact of a change of UK government in a moment. But first we need to be absolutely clear in the long run, say 5 years and beyond, it is valuations today which will dictate future returns, not the government.
 
Analysts at GMO crunch these valuation numbers. In a nutshell, they calculate future returns based on when the same conditions prevailed in the past. They figure that, over the next 7 years, large-cap US equities will return minus 3.3% per annum. Yuk. That’s not guesswork – it’s simply the maths, and is dictated by the unique over-valuation today. It doesn’t mean it is guaranteed to happen. But if the past is a decent guide, this is what we should expect.
 
Although these are the numbers for the US, we can be reasonably confident that when US equities correct (which history suggests will be falls in excess of 60%) the U.K. will follow in direction, if not precisely in scale. That is good to know, but gives us no sense of when that might occur.
 
How do U.K. valuations look against their own history? Using CAPE (cyclically adjusted price earnings ratio) the UK sits firmly in the middle ground, which doesn’t tell us too much, and is why US extreme valuations are a more useful (if gloomy) guide to the years ahead.
 
How does the possibility of a Corbyn government change this picture, if at all?
 
You might think that previous General Elections and electoral cycles would be a helpful guide – yes and no. It will surprise many that, looking at returns across the entire period in office, there appears to be no significant difference between Conservative and Labour governments. 
 
Nonetheless, it is clear that over short periods, around the election, markets prefer the idea of a Conservative administration. Even so, any short-term outperformance does not have a tendency to persist.
 
It is obvious that any new Government will prioritise the needs of those who voted for it. Therefore it is not unreasonable to assume that a Corbyn government (odds 2/1) will, one way or another, put more money back into the pockets of the less well off, who in turn are vastly more likely to spend it than those who are better off. This would be a boost to the domestic economy and smaller companies.
 
All of this gives a reasonably clear pointer. If a Labour administration becomes the most likely outcome, and then it does materialise on polling day, markets will fall sharply in the short term. The good news for investors is that this will create a cheap opportunity to buy smaller companies which, across the whole political cycle of a left-leaning government, should notably outperform – a tendency which has also been very strong in the United States, when Democrats have held the balance of power.
 
It won’t just be about smaller companies, other sectors will benefit too. For example, companies which benefit from increased government spending; the likes of brick manufacturers if there is greater emphasis on house building; even, counter intuitively, defence companies if they are based in Labour-supporting constituencies.
 
What about bonds? I don’t have the same longer term historical research for bonds. It is reasonable to assume that bond markets will be very concerned about inflation. This seems bound to push bond yields up at a time when the quantity and quality of debt makes the bond markets fragile, which is very unhelpful.
 
For example, when corporate bonds mature companies will typically re-issue them. Under Labour it seems very likely this would be at higher yields. Recent company failures (from Thomas Cook to Jamie Oliver) highlight that many businesses are very exposed to higher borrowing costs – company failures could soar, and with them bond defaults.
 
In conclusion, if a Corbyn government is elected look out for a buying opportunity in smaller companies, but do be wary of bonds.
 
FURTHER READING
Topic: Market commentary


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