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The Timid Recovery in U.K. Stocks Faces a New Hurdle

Namitha Jagadeesh and Michael Msika
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The Timid Recovery in U.K. Stocks Faces a New Hurdle

(Bloomberg) -- Just when U.K. equities were starting to look good on receding Brexit uncertainty, a general election comes along that could make or break the market.

After being long-time market pariahs, British stocks have been slowly gaining favor from both the buy and sell sides in recent weeks. An exchange-traded fund tracking U.K. mid-caps enjoyed record inflows, UBS Global Wealth Management closed its underweight position on the country’s equities and Bank of America Merrill Lynch strategists predicted further upside in the event of a Brexit deal.

But now, with the domestically-sensitive FTSE 250 Index near a one-year high, the country is heading for a general election that is set to become a proxy referendum on Brexit. Key for markets will be any outcome that reduces the prolonged uncertainty that has weighed on equities. However, it’s unclear whether any single political party will gain a clear majority to govern.

“While an election is a necessary next step in order to try and break the current parliament logjam, there is no guarantee that the parliamentary arithmetic will be improved,” said David Holohan, head of equity strategy at Mediolanum. “Given this scenario, U.K. asset performance is likely going to continue to be dominated by the strength or weakness of sterling.”

The fortunes of British equities have waxed and waned with the pound, with sterling rising this month on optimism that the U.K. will avoid exiting the European Union without a deal. The FTSE Local U.K. Index is heading for a gain of 3.6% in October, versus a drop of 1.4% for the export-heavy FTSE 100 Index of the largest stocks. The benchmark of megacaps, which tends to have an inverse relationship with the currency, was little changed on Wednesday.

Longer term, investors have been avoiding U.K. equities for years and it remained the least popular stock market in the world for fund managers in the latest Bank of America survey. But recent inflows into the Vanguard FTSE 250 UCITS ETF and the iShares Core FTSE 100 UCITS ETF suggest that any optimism on removing the Brexit overhang could spur those waiting on the sidelines to boost their exposure to the country’s equities.

“Hard-Brexit risks keep receding, which should keep supporting the pound,” said Alexandre Baradez, chief market analyst at IG. “The bouncing pound, the weakness of the British economy, and above all, slower global growth should prevent the FTSE 100 from reaching historic highs in the coming months. A comeback toward December 2018 lows seems to be the most likely scenario.”

Prime Minister Boris Johnson is the “current favorite in the polls,” Fiona Cincotta, a senior market analyst at City Index, wrote in a note. “Should he win the snap election, strengthening his mandate for Brexit, his deal could be pushed through Parliament, with Brexit signed sealed and delivered by 31st January.”

Late on Tuesday, Johnson won backing in Parliament to trigger the snap election. The vote on Dec. 12 will be the third time the U.K. has gone to the polls to choose a new government in four and-a-half-years.

Retailers, banks and homebuilders in particular got a boost in early October on hopes that a Brexit deal would be reached, and they’ll remain in focus in coming months. Further upside is possible for mid- and small-cap companies as U.K. stocks become “investable again,” Morgan Stanley wrote last week.

Any prospect of a victory for Labour leader Jeremy Corbyn, who has vowed to nationalize several industries, could put pressure on banks, utilities, defense companies and homebuilders, according to Luke Newman, a portfolio manager of U.K. equities at Janus Henderson Investors.

“We need to balance the probability of a Corbyn government,” Newman, who oversees about $7 billion in assets, said in an interview. “We’ve incrementally shorted some utility companies over the last week or so. I’d be very surprised if the election wasn’t a lot closer than the polls are betraying at the moment.”

For Deutsche Bank macro strategist Oliver Harvey, the U.K. election could be more uncertain than polls currently suggest, and recommends taking profit on U.K. trades. “We see little risk reward in having directional views on the pound or U.K. real rates until there is more certainty about the outcome of the election,” he wrote in a note.

(Updates with Wednesday’s move in fifth paragraph.)

--With assistance from Ksenia Galouchko.

To contact the reporters on this story: Namitha Jagadeesh in London at njagadeesh@bloomberg.net;Michael Msika in London at mmsika4@bloomberg.net

To contact the editors responsible for this story: Blaise Robinson at brobinson58@bloomberg.net, Jon Menon

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