Although prime minister Theresa May seems to be making some headway with the Brexit process on the divorce deal, and has at least moved onto the second-stage trade talks, there are doubts over whether she will see out her full term.
Brexit has divided the Tory party and May could very well face a no confidence vote in parliament before the UK leaves the EU at the end of March 2019.
Should she lose that, and be forced to step down, it could lead to a snap election. Judging by the lead of Labour over the Tories in current opinion polls, the prospect of Jeremy Corbyn entering No. 10 Downing Street is a real possibility.
So what are the implications of a Corbyn government on UK asset prices? Much depends on whether the Labour party’s 2017 election manifesto is adjusted as the prospect of taking office becomes more realistic. Though if the 'old Labour' 2017 manifesto is retained, the following implications seem likely:
Higher yields on gilts: A Labour government will likely lead to much wider budget deficits than under the Tories. Labour wants extra government spending worth 3.5% of GDP by 2021/22 to be paid through increased taxes on corporates, high earners and stamp duty.
However, raising tax rates may not boost government coffers as much as expected. That’s largely because richer taxpayers are mobile and could leave the UK (note: the top 1% of UK taxpayers account for 27% of total income tax).
In short, a Labour administration would mean an increase in gilt supply and place upward pressure on gilt yields. This may be offset by increased recession risks from weaker growth in domestic demand.
Index-linked gilts would offer investor protection if Labour bans zero hour contracts, raises the minimum wage and supports the unions in collective bargaining to create a more 'stagflationary' environment.
A weaker sterling exchange rate: There is a risk the election of a leftwing Labour government leads to significant capital flight from the UK. Should Labour follow through with punitive tax rates, forced nationalisations, a possible end to the independence of the Bank of England and potential capital controls, sterling would look vulnerable to a substantial correction.
This generalised uncertainty would more than likely offset the support to sterling from Labour’s softer Brexit stance versus the Tories. There is also some doubt about the commitment of the Labour leadership to closer integration with the EU, given Jeremy Corbyn’s well-known and long-held antipathy to the EU as a 'capitalists’ club'. Fears of capital controls being imposed might also accelerate sterling weakness (which would be allowable after the UK leaves the EU).
Weaker equity pricing: All stocks are likely to be marked down in the initial aftermath of an 'old left' Labour party election victory.
Thereafter, the impact would likely be more sector specific. Assuming gilt yields and base rates rise, interest rate sensitive equities would likely fall in value. The risk of nationalisation of the railways and utilities would likely weigh down on these sectors since investors would likely demand an elevated equity risk premium to hold them.
Small and mid cap businesses would be particularly vulnerable to tax rates relative to international companies, which should find it easier to shield offshore earnings from higher expected UK taxes. Infrastructure stocks could outperform on increased public spending, though for sectors like house building, recession risks and higher interest rates would be clear negatives.
Daniel Casali is a partner at Smith & Williamson and leader of the company's investment strategy team