The decision by the Conservatives and the Liberal Democrats to form a coalition Government is perhaps the best result from the market’s perspective. The arrangement commands a clear majority of MPs in the House of Commons and has the mandate to try and tackle the UK’s deficit. Both parties appear to agree on reducing borrowing and implementing spending cuts. If they can focus on the economy, the coalition may be able to deliver stable Government and alleviate market concerns.
This is important, as the markets do not like uncertainty. Any continued delay in addressing the deficit will stretch the patience of gilt investors and credit rating agencies, with higher yields being the result.
A move upwards in the gilt yield curve will mean an increase in the risk-free rate, which could lead to a rise in the cost of capital for UK companies and the cost of borrowing for individuals. It is by no means certain the UK corporate or consumer sectors are robust enough to withstand a rise in borrowing costs at this stage in the recovery, meaning a delay in addressing the deficit may only help to induce another recession.
The new Government must therefore be able to convince investors it not only has the stomach to cut the deficit but that it will be in power long enough to implement the unpopular policies that are necessary to do so.
Meanwhile, Greece’s fiscal crisis and the risk of contagion to other highly indebted eurozone and non-eurozone countries (including the US), highlights the danger facing the UK if there are delays to fiscal retrenchment.
Gilts look unattractive in the current environment due to fears of oversupply. Index-linked gilts, in addition, appear overpriced, bearing in mind the strong deflationary forces likely to be at work in the UK and the global economy over the next few years. Meanwhile, UK bank account cash returns are likely to remain slight, as banks rebuild their reserves.
So this leaves equities as the most appealing option.
Investors nervous of further volatility and/or a renewed slowdown in the UK economy may prefer FTSE 100 stocks over small and mid-caps. FTSE 100 companies on average gain more than half their earnings from overseas, so they offer some protection from any weakness in domestic demand. If sterling weakens further against the dollar then these companies’ dollar earnings will be worth more to UK investors.
Some good yields with solid dividend cover can be found among UK blue chips. It should be added that investors may prefer a global approach to blue chip investing to reduce company, sector and country concentration.
Those investors who have a higher risk appetite or a longer investment horizon, may want to focus on the small-cap area of the UK stockmarket.
It may be premature to be calling the bottom for these stocks at present but their underperformance relative to the FTSE 100 over the last six months suggests that if the new Government is able to tackle the deficit without raising fear of a renewed recession, these stocks may well outperform.
Tom Elliott is global strategist JP Morgan Asset Management