June 2017

U.K. Election

Summary

The UK election resulted in a hung parliament, with no party winning an outright majority in an outcome that will create uncertainty about the path ahead for Brexit negotiations. We see this as a mild short-term negative for UK domestic assets due to the uncertainty and prospect of a weak government vulnerable to losing votes in parliament.

Overview

We see a bigger risk of an economically disruptive ‘no deal’ Brexit – one that leaves the UK without existing trade or security agreements by the hard March 30, 2019 deadline – but also a wider range of potential outcomes, including a softer Brexit in light of parliament’s new makeup.

We see a Conservative leadership race as likely at some point. The winner of that leadership race will shape the UK’s negotiating stance with the European Union (EU) unless a new election is called.

The pound should remain a good barometer of Brexit risks. We see the election outcome as primarily a UK domestic issue and do not expect broader ramifications for global markets but do see potential implications for domestically sensitive UK companies.

Market update: UK large-cap companies versus small-cap companies

Post-Brexit, consensus was that sterling weakness would have less of an influence on UK large-cap companies, which typically have more internationally-derived revenue, while hurting UK small-cap companies, which typically derive more of their revenue domestically. But since Brexit, the MSCI United Kingdom Index has gained 23% and MSCI United Kingdom Small Cap Index has added 31%.1

However, recent returns aside, the investment rationale behind the expectation of a UK large-cap and small-cap divergence still holds, based on our analysis (figure 1). Post-vote, further sterling weakness could help drive the performance of large-cap over small-cap. The revenues generated internationally remain much more significant for MSCI UK constituents.

Figure 1: Trading places

Revenue breakdown by region of the MSCI UK and UK Small Cap indexes 

Figure 1.Trading places

Source: MSCI, as of June 8, 2017. Economic exposure refers to the source of revenue attributed to the listed regions.

Investor positioning: A hung parliament and potentially softer Brexit

A hung parliament may increase fund flow activity in UK equity Exchange-Traded Products (ETPs). Given potential sterling weakness and the possible impact on large versus small UK companies, dimensions investors may want to consider include currency hedging and market capitalization.

Up until 19 May, UK equity ETPs attracted $1 billion this year, representing the biggest net flow into any European country ETP over the period (figure 2). From 19-26 May, $500 million flowed out ahead of the general election. This data suggests increasing agreement across investors that country ETPs can be a precise way to gain exposure to political and economic outcomes.

Figure 2: Flows have paused – for now

Cumulative fund flow of United Kingdom focused globally-listed equity ETPs since May 2016

Figure 2. Flows have paused – for now

Source: BlackRock. The bars represent the monthly levels of cumulative fund flow from May 2016 through May 2017.


DOWNLOAD REPORT