UK

Heading towards a weak government

The outcome of the recent UK election has weakened the UK Conservative government’s position. Should the Conservatives fail to strike a deal with the Democratic Unionist Party to form the government, the risk of a noconfidence motion will materialise. Under such circumstances, Prime Minister Theresa May will have to resign and the Labour Party will be invited to attempt to form a government. If no government is formed within 14 days, a new general election will be called under the Fixed Term Parliament Act. In our investment strategy, we reiterate our stock selection i.e. Unilever, British American Tobacco, Reckitt Benckiser Group, Imperial Brands, National Grid and Compass Group as they exhibit the defensive quality with stable dividend and could probably present some “buy on weaknesses” opportunities. These companies have good track record with uninterrupted and growing dividend distribution even during periods of uncertainty and economic crisis. Underpinned by uncertainties and possibly a weak government, we expect the monetary policy to be less hawkish with the Brexit talks in the background. We think the gilts would rally in the near term. Thus, we would advise investors to lengthen duration and buy bullet bonds as opposed to hybrids. Our top pick in this case would be VZ 4.75% 2034. Another option would be EDF 5.125% 2050. From our fundamental analysis, we believe the GBP will underperform amidst worries over a weak government position and will be in a weaker position to negotiate the Brexit terms, a process which starts this week. The risk of potential weakening of businesses may emerge while rising inflation could take a toll on consumer spending underpinned by low wage growth. Our empirical analysis suggests the GBP could fall below the pre-election levels of around 1.24 against the dollar from a 1 standard deviation point of view. Should that happen, the ringgit may reach around the 5.30- 5.35 levels against the pound.

A. UK Election Outcome

• Out of the 650 seats, the Conservatives won 318, Labour garnered 262, Scottish National Party bagged 35, Liberal Democrat had 12, Democratic Unionist Party snapped 10 while others took 13 seats respectively. The Conservative’s effort to seek a stronger mandate for Brexit negotiations has been weakened with the loss of a parliamentary majority.

• Nevertheless, the Conservative party should be able to form a working parliamentary majority if talks with Democratic Unionist Party succeed as it will bring in a combined 328 seats, slightly more than the required 326 seats.

• Should the Conservatives fail to strike a deal with the Democratic Unionist Party to form the government, the risk of a noconfidence motion will materialise. Under such circumstances, Prime Minister Theresa May will have to resign and the Labour Party will be invited to attempt to form a government. If no government is formed within 14 days, a new general election will be called under the Fixed Term Parliament Act.

B. Investment Strategy Equities

• In our recent investment strategy just before the UK election, we embarked on a defensive approach. The stocks that we suggested are those that will be less vulnerable to the outcome of the election. In other words, these stocks are less sensitive to whether the Conservative wins by two-thirds majority or simple majority or in the event of a hung parliament or even the extreme situation of a Labour victory.

• We like Unilever, British American Tobacco, Reckitt Benckiser Group, Imperial Brands, National Grid and Compass Group as they exhibit the defensive quality with stable dividend and could probably present some “buy on weaknesses” opportunities. These companies have good track record with uninterrupted and growing dividend distribution even during periods of uncertainty and economic crisis.

Fixed Income

• Given the current scenario of a hung parliament, we expect the monetary policy to be less hawkish with the Brexit talks in the background. We think the gilts would rally in the near term. Thus, we would advise investors to lengthen duration and buy bullet bonds as opposed to hybrids.

• Our top pick in this case would be VZ 4.75% 2034. Verizon Communications is the largest wireless provider in the US. It has the highest EBITDA margin among its peers in the US telecom industry at around 38% in 2015. Verizon’s credit metrics are strong with an EBITDA interest coverage of 6.5x and debt/EBITDA of 2.9x in 2015. It has limited overseas exposure.

• Another option would be EDF 5.125% 2050, issued by EDF, an integrated energy company 85% owned by the French government. Despite headwinds from low power prices, earnings have been stable. An increase in capital expenditure to build a nuclear power plant in the UK should be mitigated by deleveraging plans and government support.

Currency

• From our fundamental analysis, we believe the GBP will underperform amidst worries over a weak government position and will be in a weaker position to negotiate the Brexit terms, a process which starts this week. The risk of potential weakening of businesses may emerge while rising inflation could take a toll on consumer spending underpinned by low wage growth.

• Our empirical analysis suggests the GBP could fall below the pre-election levels of around 1.24 against the dollar from a 1 standard deviation point of view. Should that happen, the ringgit may reach around the 5.30- 5.35 levels against the pound.

Source: AmInvest Research - 13 Jun 2017