Big Boris victory to fire up capital markets
Capital markets are set for a surge of adrenalin on Friday after Boris Johnson’s Conservative Party secured a thumping majority in the UK’s general election, removing a huge weight of uncertainty about Brexit. With hopes also leaping of a US-China trade deal, government bonds, equities and sterling will all move in a risk-on direction on Friday — the only question is how far.
“It takes a lot of pressure off,” said Tom McPhail, head of policy at Hargreaves Lansdown, the UK’s largest retail investment platform. “We’ve now got a fairly clear path, and that clarity will be welcomed by a lot of people. Parliament will be recalled, we’ll have a Queen’s Speech next week, and it will give the government a much stronger mandate, with less risk of disruption from backbenchers on Brexit.”
BNP Paribas said it expected the 10 year Gilt yield to rise towards 1%, from recent levels around 0.8%. As recently as October they were at 0.4%.
But attention will soon turn to the serious challenges facing the UK, above all the difficulty of negotiating a future trading relationship with the European Union.
Any lingering hopes that the UK could escape Brexit died last night. Asked whether the UK was now certain to leave the European Union at the end of January, McPhail said: “In as much as anything is a political certainty, yes. I cannot see anything that will disrupt that. They will bring the Withdrawal Agreement bill back before Christmas and they’ve got the majority to push it through.”
But a rates investor in the UK termed the result a “sugar high” and warned the enthusiasm could be short-lived. “In hindsight, the market was clearly nervous,” he said. “Given the weak [election] result in 2017 after a slight narrowing in the polls, we were braced for a long night. In the end, it was pretty much over by one minute past 10.” That was when exit polls predicted a big Conservative majority.
The move in sterling futures indicates that the strength of the Conservative win was a surprise. By 7.30am sterling had risen to $1.344 against the dollar, up from $1.307 on Thursday evening.
Volatility in the FX options markets was quashed almost immediately when the exit poll came out. There had been an increase in put buying in the week before the election, but this disappeared when the result became clear. An interdealer broker said his bank clients had told his staff by 1am to get a few hours of sleep, since activity was so low.
“The currency gives us a good initial sign of where the market is going,” said the head of UK rates at an investment bank in London. “I expect the spread of Gilts to Bunds to challenge the high point of the year — 120bp.”
At Thursday's close, the 10 year Gilt was yielding 108bp more than the Bund.
BNP Paribas analysts thought the result meant "the Bank of England's base case remains intact and as a result reduces the chances of a near term rate cut". A capital markets investor at a major fund manager said he thought there could even be a higher chance of a UK rate rise late in 2020, though that would depend on who took the helm at the Bank of England.
UK stocks are likely to leap on Friday, as investors react to a stronger economic outlook for the UK. The new Johnson government is likely to hold a Budget soon, which will include “a fiscal boost”, analysts at BNP Paribas predicted.
“The futures market is showing an open of 7299 and we’ve got a cash market that’s pointing to an open of around 7300,” said Neil Wilson, chief markets analyst at Markets.com, the UK retail trading platform.
This 0.3% rise was just the initial reaction, however, based on the “fumes” of traders repositioning. When the cash market opens, Wilson said, he would expect “the big money” from fund managers to start seriously reallocating to the UK.
“If you look at UK equities being so cheap, there’s been a discount applied to them. The forward price/earnings multiple is about 12, compared with 15 for France and Germany, 18 for the S&P and 21 for the Nasdaq,” Wilson said. “That multiple is not sustainable if you remove all this uncertainty.”
The night’s trading suggests that the pattern since the Brexit referendum of the pound being inversely correlated with the FTSE 100 will be broken today, and Wilson thought that change could last, reverting to the pre-Brexit pattern of “a more natural correlation between a strong UK PLC, a strong pound, strong FTSE”.
After sterling's leap during the night, on Friday it will test the levels of around $1.36 to $1.37 at which it last peaked in May 2018, Wilson predicted.
UK equity capital markets bankers have long hoped for a Conservative majority to boost trading conditions in January. But their prayers may have been answered even sooner. Some hope a sudden surge in risk appetite and bounce in sterling might open up a trading window even next week for accelerated bookbuilds, even though markets are normally quiet this close to Christmas.
“There now might be a trading opportunity into the UK next week,” said the head of EMEA equity syndicate at a US bank. “It’s obviously late in the year to do things but there now could be a window for some things.”
November and December have been busy months for equity block trades as sellers took advantage of rising stockmarkets and improving investor sentiment to execute transactions.
Banks say some issuers avoided the market this week because of the election. With that uncertainty out of the way and the Conservative Party assured of a strong majority, those issuers could come to market now. “There is some pent-up supply which didn’t come before the election and that could trigger trades next week,” said a second syndicate head.
Another risk hanging over the market also appears to have been lifted. Investors had been fearing US president Donald Trump would impose another round of tariffs on Chinese imports, but his Twitter feed switched on Thursday to trumpeting a "big deal" and later in the evening the deal was confirmed by the Trump team.
The US will halve its tariffs on $360bn of Chinese imports and cancel new tariffs on $156bn of products.
“With the US and UK both getting good risk-on news, they’ll likely assist each other because of the correlation effect,” said an investor.
This detente has already lifted stocks around the world, with Shanghai up 1.8%, Tokyo 2.5% and Hong Kong 2.3%, and that provides a strong backdrop for ECM deals.
However, the head of EMEA ECM at a leading firm said he thought trades before Christmas were less likely and he would advise clients to go for January.
The capital markets investor also thought ECM issuance might not react quickly, because deals took time to put together, though there could be some activity.
He thought bond issues were more likely. "There could be opportunistic, drive-by issuance by UK companies over the next week," he said.
However, while confidence is high and Gilts, particularly at the short end, are set to sell off, market participants are concerned that the move will be short-lived. “Once the drunkenness is over, the hangover kicks in,” warned an investor. “The UK is out of purgatory, but there are some seriously big issues out there.”
Perhaps the most concerning is the future of the UK’s trading agreement with the European Union. “While the majority is likely to give Boris Johnson some room to negotiate, it’s far from a settled question,” said the rates investor. “There is some hope of an extension beyond 2020, but that’s not my base case.”
Bunds opened weaker, according to one senior debt capital markets banker, perhaps reflecting the end of any slim hopes of Brexit being cancelled. It may also be a reaction to the US-China trade detente.
The rates investor warned that, with the Scottish National Party having won nearly all the seats in Scotland, the question of a second Scottish independence referendum could rear its head once more.
The UK economy is also not a picture of health, which will temper investors’ enthusiasm for selling Gilts. “Given the scale of the majority, there will be a bit of a boost to sentiment, but growth is stagnant and the labour market is fragile," he said. "We’re relying on business investment picking up, but that’s far from a given. I certainly don’t see the Bank of England hiking rates any time soon.”