Trading the Upcoming U.K. Election

Next year’s U.K. general election is anything but a sure thing. With the two mainstream parties polling neck and neck--and growing support for the anti-EU U.K. Independence Party--investors are already bracing themselves for an inconclusive result next May when voters head to the ballot box.

That said, some of the City's finest brains have offered up strategies on how to trade the relevant markets given this uncertainty.

Lars Kreckel, Legal & General Investment Management’s equity strategist, noted that elections don’t tend to have a large and lasting effect on stock markets. Even so, political uncertainty is “worth a bit of risk premium,” which adds to a growing list of compelling reasons to favor other equity markets over the U.K.'s benchmark FTSE 100 index.

When it comes to specific sectors, Nomura strategists believe a victory for the opposition Labour Party would be a “clear negative for utilities” with the party planning to force energy firms to freeze prices until 2017. Shares in energy companies such as Centrica PLC and SSE PLC would be hardest hit.

Labour’s tougher stance on U.K. banks could hurt HSBC Holdings PLC, Barclays PLC, Royal Bank of Scotland Group PLC, Banco Santander SA and Lloyds Banking Group PLC, according to Nomura, but a Conservative-led government promising a referendum on European Union membership could be an equally damaging result for the sector.

Homebuilders should fare well either way. Labour has pledged to significantly increase the rate of house building to 200,000 per year by 2020 and the Tories have announced pro-building polices as well.

Fixed income and currencies provide another way of trading the polls, which is arguably more result agnostic. But as the Scottish referendum in September vividly illustrated, these markets don’t tend to pay attention until the very last minute.

The volatility of sterling options--a measure of how nervous the market is about future wild currency swings--sank to multi-year lows over the summer, only to be awakened by a poll showing the pro-independence camp in the lead shortly after traders returned from the beach.

Volatility hasn’t always reacted in the same way around general elections, Nomura strategists conclude after studying market reactions to U.K. votes going back to 1992. But there are two clear themes: jitters as measured by FX volatility tend to fall between the end of November the previous year and the election date, and rise immediately after the result.

As a result, the Japanese bank recommends selling sterling options for the first few months of 2015, and then buying them after that in expectation of their value rising.

“We do think [the elections] will weigh on [the pound] and will certainly be a vol event,” the Nomura strategists noted.

Morgan Stanley economists agree that political and fiscal uncertainties are likely to pose increasing risks to sterling over the coming year. They tout selling the pound against the dollar as one of their top trading ideas for 2015, having lowered their target for the currency pair to $1.45. It’s now trading around $1.5550.

“Even after the election, the uncertainty is likely to be prolonged, with several of the policies of the major parties set to be less than favorable for [the pound],” the U.S. bank's economists noted, citing tighter fiscal policy and questions over a U.K. exit from the EU in particular.

Morgan Stanley also predicts a gradual drop in U.K. government bonds. Nomura believes the 1992 general election--when an unpopular Conservative government managed to overhaul a deficit in the polls to win a surprisingly comfortable victory over Labour--provides the closest parallel to the current scenario.

Back then, yields of five- to 10-year gilts sold off between 0.7 and 0.9 percentage points in the month prior to the election. Interest rate swaps also widened in a sign that investors wanted to protect themselves against a potential rise in market interest rates.

Nomura believes swaps offer the best way to take a view, as outright positions in gilt markets will be susceptible not just to Bank of England commentaries, but also the evolution of monetary policy by the U.S. Federal Reserve and the potential for sovereign quantitative easing from the European Central Bank.