As we approach the most uncertain election this country has seen in years, Stephanie Baxter looks at the risks schemes are likely to face.
Political risk is always difficult to quantify, not least with the forthcoming general election, which is undoubtedly the most uncertain the UK has had in years.
The result could cause disruption in the markets especially with the likelihood of yet another coalition government that may be challenging to form. Pension schemes should expect volatility around the election, and a sell-off in UK equities is not entirely inconceivable. How on earth do schemes prepare for an election that is impossible to call?
Schroders senior European economist Azad Zangana says the key thing for investors to consider is higher volatility in the markets. He adds: "If you're sensitive to that then you need to ensure you have hedges in place. But for this election it's more complicated because we have a number of results that could come out."
Trying to position portfolios for this election is a huge gamble. UK equities have had a fantastic run since the credit crunch but now investors are living in a world of lower returns.
"We will probably see lower returns going forward but with a lot of volatility around that," says Hymans Robertson head of investment John Walbaum.
He sees the election as a short-term factor in raising volatility in the markets both before and after the election, depending on who wins and what happens thereafter.
What could happen?
An outcome where the Conservative Party wins a majority of seats will probably cause the least volatility, although this is unlikely given recent polls. "The markets would settle pretty quickly," says Walbaum.
The Tory promise of a referendum on the UK staying in the EU could concern international investors, however, which could be negative for sterling. Zangana says it is less clear what this would mean for equity markets: "Some companies will do well from the falling pound but others will be concerned about the potential impact on their business in Europe."
While the Tories will just carry on with their austerity programme over the next five years, Labour will look to balance the books over a longer period through imposing higher taxes.
If Labour wins then markets will be looking to see what the party's manifesto pledges look like, such as how much public spending will be cut and where taxes will rise. Given this uncertainty, which markets do not like, Walbaum believes this may be a more volatile scenario although it "doesn't mean markets will go down in the long term."
How Labour's attacks on utilities and banks in recent years feeds into its actions in government is also a concern for some industries.
The more likely scenario of neither party winning an outright majority is much more concerning, however. Forming a coalition government will be challenging and involve a great deal of political wrangling which will raise volatility in the markets. This will be particularly marked if the election results in a coalition between Labour and the Scottish National Party (SNP), according to some.
Franklin Templeton UK equity income fund manager Colin Morton says: "Recent polls show that while the SNP would only get 4% of the national vote, they could easily end up with 30 MPs compared to their current five. That's a big issue because they won't support Tories and are much more likely to support Labour."
A particular concern for Morton is a pledge from SNP leader Nicola Sturgeon to put an extra £180bn into public spending, claiming that austerity has failed.
He says: "I don't think the markets would take too kindly to this. These things have the potential to cause short-term disruption in the UK equity markets."
A recent Daily Record/ Survation Scottish poll suggests the rise of SNP could cost Labour the election and that a Conservative/ Liberal Democrat coalition would be the likely result.
Morton believes there is actually not much difference between the parties when it comes to the big decisions such as tackling the country's deficit. "There will be a few changes between the parties but they're all committed to reducing the deficit over the next five, six or seven years," he says.
The greatest concern for markets is that in the event of another coalition, will it actually be workable? The worst scenario would be a coalition of two, three or four parties that can agree on very little.
Zangana says: "Even if we end up with a coalition, it may not last for very long so chances of another election later in the year are quite high. That is quite negative for UK markets."
Morton says this would "severely impact" markets in the short term.
International investors could be frightened off by such events, leading to a major sell-off in UK equities.
Morton does not believe it would come to that, however. He says: "Everyone internationally is watching with interest but they are still willing to believe there will be a reasonably sensible outcome. Even if it isn't as sensible as they hope for, the actual policies will still be reasonably sensible as there are things the parties will have to do."
If we remove the election uncertainty, the UK is looking in pretty good shape with low oil prices, falling food prices, low inflation, rising house prices and the strongest average earnings for years. For long-term investors, it is important to look at the bigger picture rather than worrying about who will be in charge after the election.
The positive data are not being reflected in the profits and earnings of companies, however. Walbaum says: "Companies are under pressure for a number of reasons such as currency strength and oil price weakness. Across a lot of financial institutions regulation and unburdening balance sheets are ongoing issues. Given the price of the equity market is well ahead of earnings, it is potentially a little fragile anyway."
Hymans Robertson is pretty cautious on UK equities although is not recommending that investors sell them. Rather, if schemes have scope to take profits then now is probably a good time to do it, says Walbaum.
"Schemes may well be in a position where they've had a very good run in equities and may want to capitalise on some of that and remove exposure to some of the uncertainty," he adds.
The impact of election uncertainty on equities could be mitigated by the fact that most large UK-listed companies generate most of their business from foreign markets. If the UK was hit really hard by political concerns it would probably create a buying opportunity, according to Morton.
For pension schemes it is a case of wait and see while avoiding making rash decisions based on a wild guess on what may happen on 8 May. Zangana suggests taking a calm and cautious attitude in the run up to the election: "Investors should ensure they're fairly agile during the period and be ready to act on volatility if necessary when the results become clearer."
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