Election 2010: Where I am investing my SIPP

Last week Rob Kyprianou, one of Britain's foremost economic and investment experts, explained why the impending UK election was important for SIPP investors – you can read the article here. Here he explains how he has reacted to the uncertainty of the election result and the fiscal consolidation policies that may follow.

I have argued in a previous article that dealing with market uncertainty and risk is the key to successful investment management. As I noted, there are many approaches which can be deployed, but whatever technique you are comfortable with it is important to be disciplined in implementation. One technique implemented while I was at Salomon Brothers Asset management 20 years ago is called Scenario Dependent Optimisation (SDO).  The smart rocket scientists at Salomon implemented this through a sophisticated multi scenario mean-variance optimisation tool that could look at the impact of a range of alternative forecasts on a large number of markets. However, the principle of SDO can be deployed even without sophisticated modelling tools, in particular when faced with a key event risk such as an election.

The approach is based on anticipating the impact of a range of different outcomes - in this case the election result - on markets. In doing so we are looking for market reactions which occur whatever the outcome of the election, or for markets that have the best or worst performance prospects across the different election results.  For example, the three election results I considered were a Conservative majority, a Labour majority or a hung Parliament and then looked at the impact on UK equities, UK bonds and sterling in each of these ‘scenarios’.  These are my views:

Conservative majority: prospect of a ‘better’ balance of tax/ spend policies that will not hold back growth, corporate profits or private incentives. A government debt ratings downgrade is less likely, although huge debt issuance will still overhang the gilt market. Sterling may react positively to better likelihood of sustainable growth and debt consolidation.

Labour majority: tax AND spend is likely to follow which will make sustainable growth and fiscal consolidation difficult. A downgrade of government debt is more likely and the concerns for supply will only grow, while sterling is likely to react badly to this outlook.

Hung Parliament: whatever the makeup, the prospect of compromise policies and fears over the sustainability of any coalition at a time when the economy and public finances require strong and decisive action will not be good for UK assets and sterling. This will be particularly bad for gilts as two party’s political interests in government compromise debt management.

When I examine these scenarios and market outcomes my conclusions are that i) it is very difficult to find a good scenario for UK government bonds, and ii) the impending outlook for a hung Parliament is particularly damaging for UK assets.

What is the impact on portfolio strategy for my SIPP?  As previously noted, I have a high level of cash, hold no government bonds (other than indexed linked held as an inflation hedge) in favour of corporate bonds, with a low allocation to UK equities in my equity portfolio. My SDO analysis of the UK election makes me very comfortable with this asset allocation. However, I have responded with some changes. I have raised cash further by:

1. Reducing my corporate bond holdings. My corporate bond funds have rallied by between 30% and 60% in the past year and have some duration (a measure of the sensitivity of bond prices to interest rate changes) and may therefore not be able to resist a rise in government bond yields.
2. Reducing my UK equity holdings. With the market at around 5750, up 45% percent over the past year, the balance of risks from the election are not adequately reflected in equities.
3. Reducing my holdings in commodity equity funds. Although not directly related to the UK election result, I have reduced my holdings now, firstly to hedge my view on government bonds as the only exogenous reason I can see for a bond rally is a collapse in commodity markets; and secondly, commodity markets have strongly recovered in the last year with my commodity equity funds reaching mid 2008 levels when there were fears of commodity bubbles and when the outlook for growth was a lot better than in the post financial crisis world.

As I result, my cash is 56% of the portfolio and bonds 11.5%, while the UK now accounts for less than 25% of my holdings in equities. In my view, there will be better opportunities to buy UK equities. Distracted by the election campaign, lulled by a strong stock market rebound over the past year, and comforted by the fact that massive monetary policy stimulus succeeded from pulling the UK back from the financial crisis precipice, I believe the market has lost focus on the seriousness of the economic situation. The economic recovery so far from the worst recession since the Great Depression has been anaemic and more money and incentives will be drained by already announced tax increases. The election, unless there is an outright strong Conservative victory, does not seem to offer an investment case at these levels.

Of course you may have your own scenarios or views on the subsequent market reaction which you may wish to apply, but the SDO approach should still be useful. Furthermore, the short term immediate reaction to the election will be influenced by what is priced into the market and whether there are any surprise outcomes. However, this should not distract investors from the longer term fundamentals that will follow.

Rob is walking 1000 Miles in 2010 to raise £100,000 for MS Research. You can find more details here: http://1000miles4hope.com.