Following Theresa May’s announcement for a ‘snap election’ on the June 8, the U.K. has ended a brief era of fixed-term parliaments that lasted a mere seven years. The impact of this election has caused speculative activity among traders, with sharp moves in both the value of pound sterling and U.K. companies.
The Long-Term Impact on Markets
Many investors are especially interested in the impact of the U.K. election on U.K. company shares, U.K. government bonds and the pound sterling. However, before considering the impact, it is worth reminding ourselves of recent developments in the difference between price and fair value.
Over the last few years, both the number and range of attractive opportunities in the U.K. have declined and consequently the outlook for investors has worsened as asset prices rose relative to their long-term fair value. As one key example, U.K. company shares rose strongly in price in the second half to 2016, following the Brexit vote, further reducing the long-term expected return for investors. While our portfolios benefited from this rise, we are looking forward to the opportunity to increase our exposure to this high-quality market at a lower cost.
Such an opportunity may be provided by the impact of sterling on the near-term profits of these businesses. In contrast to the swift recovery in share prices since the Brexit referendum, sterling has been noticeably weak of late as it has borne the brunt of Brexit fears. While we have used this weakness to increase our exposure to sterling, this weakness has created a positive tailwind for share prices in a market dominated by global companies who earn significant profits in other currencies, most notably the US dollar.
While this sensitivity to the dollar/sterling exchange rate can have a significant effect on short term profits, its relationship to the long term fair value of a company is far less certain. Consequently, these currency-driven changes in share prices can create excellent opportunities for investors.
UK government bonds constitute a major part of most U.K. based investors’ portfolios. We have long regarded these assets as very unattractive, expecting them to deliver a real, after inflation, loss for holders over the long term and have increasingly favoured overseas government bonds. However, as an asset class that is typically sensitive to political risk, the outlook for U.K. bonds may well improve over the election process. However, it is worth acknowledging that prices would have to move a long way before these assets became attractive as anything other than a hedge for short-term volatility.
Opportunity Amid Chaos
The key take away is that political change instinctively has an impact on investment markets in the short term but rarely has a sustainable impact in the long term. Hence, such episodes can create opportunities for long-term investors who are prepared to think independently.
As we focus on new opportunities, we are also reminded that periods of uncertainty are characterised by ‘path dependency’ for investors. To put it another way, there is not simply a wide range of outcomes but these outcomes may occur in various orders. For example, while some would have predicted another election following the Brexit vote, few would have predicted this following the successful execution of Article 50 and the ongoing availability of a conservative majority in the House of Commons.
Consequently, the uncertainty associated with significant geopolitical events is not only wide but also long. This longitudinal aspect of uncertainty means predictions can be both right and wrong depending upon the timescale over which they are judged. In this environment, humans are especially vulnerable to remembering the times when their predictions appeared correct and forgetting those moments when they appeared less prescient.
Therefore, the U.K. election can also create dangers for investors. Chief among these is the temptation to react too quickly or with too much confidence in the outcome of an event. This lesson was strongly reinforced by the market movements following the U.S. election last year.
There are two ways that we combat this challenge. The first is to remain firmly focused on the long term, shutting out the market noise associated with such events, you won’t find any large TV screens showing financial news in our office but you will find many books written by great long term investors. Second, we tend to focus intently on the intrinsic value of an asset, acknowledging that the volatility of market prices and the behavioural biases of other investors may provide better opportunities to make changes in the future.
As valuation-driven investors, we will therefore continue to prioritise fundamental analysis, looking for assets that have become unloved by other investors and are priced cheaply enough to deliver an attractive reward for risk. While we consider each potential opportunity individually, as portfolio managers, we are also cognisant of the overall risk in portfolios. We have therefore typically increased the amount of cash we hold in portfolios as the expected returns of existing holdings have diminished and we patiently search for new, long term, opportunities.
