Multi-assetMar 26 2015

Take stock of election jitters

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This year could turn out to be a pivotal one for the UK market. Already in Q1 we have seen the FTSE 100 Index reach an all-time high, surpassing a level last seen in the heady days of the technology bubble back in late 1999, and in the first week of May the UK electorate will go to the polls in what could be a defining election for the future of the UK.

To many, this may seem like an anomalous situation given that this election is looking like being the closest and most uncertain in the past 40 years. Unsurprisingly, this is creating challenges for anybody who allocates to UK equities, with key questions about how to play the market this year.

One of the main winning strategies for investors in the UK over the past 15 years has been to simply have an overweight position in mid-cap companies with the FTSE 250 ex-IT Index delivering enormous outperformance of the FTSE 100 Index. In fact, since ending a period of underperformance on 28 December 1998, the FTSE 250 ex-IT Index has outperformed the FTSE 100 Index by more than 200 per cent to the end of February 2015.

This strategy is all well and good, but it clearly has not been without periods of volatility and pain. Essentially, investors following this approach have been running significant tracking error risk against the FTSE All Share Index, which at various times has caused painful periods of relative underperformance. As with any rotation in the stockmarket, these periods generally catch people by surprise and the movements are often sharp.

In the first part of 2014, the rotation from mid cap back to large cap caught many investors by surprise. The result was an underperformance of almost 10 per cent in just eight weeks. The proof of just how active managers were positioned was highlighted by looking at the best performers in the IA UK All Companies sector over this period. Perhaps surprisingly, five of the top 10 funds were FTSE 100 Index trackers, as active UK managers positioned themselves away from the largest companies in the UK.

While the lesson in history is interesting, looking forward is clearly more important. However, knowing what risk you are taking with your positioning is crucial. With the election causing a potential headache for UK investors, understanding how your exposure is likely to perform given various scenarios makes it far easier to understand and predict performance.

The challenge now is to determine how much active risk managers are prepared to take given the risk events that are ahead of the UK market. There is never much upside in trying to predict politics, and the difficulty this time round is that it is conceivable that every outcome bar a clear Conservative majority is potentially challenging for UK equities – and the odds on an outright Conservative majority are very small indeed. It would appear an almost certainty that the country will end up with either another coalition or minority government, with the latter looking ever more likely given the level of squabbling between the major parties.

Every likely outcome would appear to create some level of uncertainty, be it the prospect of the SNP as part of a coalition, a weak minority government that cannot get its policies through, or a Conservative government that pushes forward plans for an EU referendum. With markets near record highs, none of these political outcomes creates a business environment conducive to growth and confidence.

While there is more to the market than politics, when looking at earnings the picture does not seem to be much better. Research from JP Morgan indicated that FTSE 100 earnings peaked in 2010 and has been falling ever since – given the heavily skewed structure of the index towards financials, oil and gas, resources and food retail it is perhaps not surprising. But looking forward it is hard to see any major catalysts for this to reverse.

A further issue facing the UK this year is currency and the fact that the world is in the middle of a global currency war. While the UK is benefiting from the strengthening of the US dollar, at the same time sterling has strengthened significantly against the euro as the full effects of European quantitative easing is seen. This is making the UK’s goods and services look far more expensive for our key trading partners in Europe and there is no end of this in sight, not least because the UK will enter an interest rate rising cycle long before the EU has even finished its QE programme.

So with a number of challenges facing the UK, how should you position your UK equities? Clearly, the picture painted above is not a patricianly rosy one and investors need to be braced for a significant uptick in volatility in the run-up to the election, and in all likelihood, beyond. Historically, increasing volatility in the UK has seen the FTSE 250 Index underperform the FTSE 100 Index and as seen earlier, this can be sharp and painful, which makes it imperative that investors in UK equities understand the risk exposure they are running in the UK. With many likely to be sitting on significant gains from large mid-cap exposures over a number of years, rotating some of this back towards large cap equities to reduce tracking error and relative risk may be prudent in the short term.

Perhaps most interesting should be those managers that have the ability to capitalise the most on increasing volatility. This should play into the hands of long/short UK managers with the opportunity to capitalise on both the winners and losers that fall out of challenges ahead of the UK market. With the prospect of uncertainty dragging on well into next year, particularly if the European referendum is back on the agenda, this approach has the potential to make the most of a broadening dispersion of returns that is likely across the market.

Ultimately, with UK markets close to all-time highs, there looks to be strong headwinds facing the UK markets. As such, it appears to be time to be prudent, with an eye on the risks within an investor’s UK exposure and to think about strategies that have the ability to protect against what could potentially be a prolonged period of UK stockmarket instability.

Ryan Hughes is a fund manager of Apollo Asset Management

Key points

In the first week of May the UK electorate will go to the polls in what could be a defining election for the country’s future.

The challenge now is to determine how much active risk managers are prepared to take.

Every likely outcome from the election would appear to create some level of uncertainty.