Two days before the U.K. general election there is no way of knowing who will be the winner. One thing is sure, however: No matter what the result will be, the ride ahead isn't smooth. The pound seems to anticipate this. It has lost some ground to the U.S. dollar as the election approaches, trading more than 1% down in the past week, but stocks have remained remarkably sanguine.
The FTSE 100, which hit a new record high of 7122.74 on April 27, is only a little over 100 points below that record. This could be to some extent because more than 70% of the U.K. large-cap companies are multinational businesses, so the British election does not really affect them. Another reason could be that investors expect continuity. However, this is where they could be wrong.
Virtually all the British newspapers -- which by tradition come out and support their favorite party before the election -- have said they back the incumbent center-right Conservative party, with the exception of left-leaning daily The Guardian, which is a Labour supporter. Most pundits and stock commentators say that a Conservative victory would be the best outcome for markets and praise the current government's performance.
As recently as this morning, UK Chancellor George Osborne welcomed on Twitter the European Commission's growth forecasts, which show that Britain is likely to be among the fastest-growing countries in the EU this year. The U.K. economy is expected to advance by 2.6% this year and by 2.4% next year, compared with the EU average of 1.8% and 2.1%.
And yet, some analysts are less than impressed. Outspoken Societe Generale economist Albert Edwards is renowned for his bearish, but very realistic take on the economy. He recently warned that "the U.K. economy stands alone, up to its eyeballs in macro manure."
Why is he saying this when on the surface things look so good? Well, the European Commission's forecasts also contain things that Chancellor George Osborne would not like to be reminded of. The U.K. current account deficit is seen at 4.9% of GDP this year and 4.1% next year, vs. an average surplus of 1.9% in the EU. The budget deficit is seen at 4.5% of GDP this year and 3.1% next year compared with the EU average 2.5% and 2%.
This issue of "twin deficits" has not been discussed too much in the election campaign, but investors are looking at it because the deficits are the visible symptoms of an essentially imbalanced economy. While the U.K. bounced back from the worst recession since the Great Depression much quicker than other European countries, it did so by sacrificing its stability. The future government will have to deal with the challenges, which are the worst among developed countries.
Source: Societe Generale
Many critics have slammed the Conservatives for cutting spending on the most vulnerable categories in the society, and evidence of tighter local budgets has emerged in the form of less spending on public cleaning or lighting. But Edwards says the government has in fact "quietly abandoned all pretence at fiscal cuts, kicking the can into the next parliament." He adds: "Basically the coalition government saw the recessionary impact of its early attempts to cut the double-digit public sector deficit combined with the eurozone crisis and reversed course."
The Crucial Housing Market
The government's fiscal stimulus has been mainly directed toward the property market, because traditionally in the U.K. rising home prices have underpinned wider recoveries. It worked in two ways: first, various tax breaks have encouraged private investment in assets, and especially in property, with buy-to-let property owners able to deduct the cost of interest on the mortgage and of investing in upgrading the properties. Second, more or less open subsidies have maintained and even boosted home prices; the government is guaranteeing part of the deposit for certain categories of buyers and is promising to subsidize a 20% reduction in home prices for buyers younger than 40 years of age.
However, all this has deepened the inequality already existing in the U.K. and has sparked worries about a housing bubble, the bursting of which could take down the entire economy. In fact, the need to do something about sorting the U.K.'s housing crisis is the one thing in common for all political parties -- but they go about it in different ways.
A victory for the Conservatives would be good for most stock market sectors if history is any guide, except perhaps the banking sector, where more regulation and a tax on banks have prompted a threat from HSBC (HSBC), Europe's biggest bank, that it would move its headquarters out of London.
A victory by Labour, by contrast, would see many sectors suffer. Labour leader Ed Miliband promised to freeze energy prices, so utilities and the energy sector won't welcome his victory. He has also said he would impose a "mansion tax" on properties worth more than 2.0 million pounds ($3.05 million), which will likely drive luxury buyers away, so the luxury industry and London estate agents could take a hit. He will also reduce the amount that well-off people can save in their pensions and get tax relief on, therefore investing in asset management companies or banks would not be a good idea if he wins, either.
The one sector that both big parties are likely to help is that of home building, although, ironically, a Labour victory would be better for it than a Conservative one. The Labour party promised that one million new homes would be started in the next five years, while the Conservatives have promised to first sell social housing preferentially to social tenants and then start building with part of the proceeds. Therefore companies like Taylor Wimpey, Persimmon or Crest Nicholson, all listed in London, would benefit regardless of who takes power.
But while stock picking ahead of the election could be fun, investors would do well to beware of the moment when the markets get overpowered by the "macro manure" mentioned by Edwards. He is convinced that sooner or later this will happen. "Eventually the stench will fill the nostrils of currency markets with the inevitable result -- another sterling crisis," he says. Watch that pound.