The UK General Election on 8th June is likely to trigger heightened volatility in UK related markets including the UK100 (FTSE underlying), GBPUSD, EURGBP, GBPJPY and UK stocks. This article evaluates the likely election scenarios and highlights potential trade ideas to take advantage of any volatility that may arise from the result itself.
Setting the scene
Last month when UK Prime Minister Theresa May called a snap election for Thursday 8th June, the immediate reaction in the markets saw the GBP surge higher and the UK100 (FTSE 100 underlying) plummet as traders reacted to the announcement of yet another political event that could potentially have a major impact on the markets. In the weeks since the announcement was made, we have seen the pound continue to push higher and break back above the 1.30 handle against the US dollar - a 7 ½ month high - whilst the knee-jerk reaction in the UK100 has reversed and the index printed all time highs of 7570 just this week (31st May).
What caused these moves?
The general consensus for the reason behind the rise in both the pound and the UK100 since the election was called is that the incumbent Conservative party will significantly strengthen their MP majority in parliament. Despite winning an unexpected majority in the 2015 election, the narrow margin with which it was accomplished has meant that there is very little political leeway for the Conservatives to get their policies ratified in Parliament. This inhibits the party’s ability achieve its goals as losing the support of even a handful of Conservative MPs could mean that bills are watered down or blocked.
As with most things in UK these days, the imminent Brexit is playing a major role as PM May can ill-afford to alienate eurosceptic Tory backbenchers given she relies upon their support due to her small majority. Along these lines, the snap election can be seen as a political power grab by the Conservatives whose standing has markedly improved since the last election amongst pollsters, with a consensus now forecasting a gain of around 80 seats (The conservatives currently hold 330 seats with 326 or above giving the majority of the 650 seats).
Returning our focus to the markets, an expectation of a significant growth in the Conservatives majority would impart far greater political power on the ruling party and - it is assumed - allow far greater leeway in the Brexit negotiations with the EU (as Theresa May would rely less on the support of her Eurosceptic MP’s to ratify a Brexit deal). This alongside the certainty that a strong majority brings was seen as positive for the pound and the UK economy in general which could explains the bullish market reaction in GBP crosses and the UK100.
Whilst there are clearly too many permutations to run through an exhaustive list of scenarios here are three that could occur on 8th June (note these are not necessarily in order of most likely to occur):
1) Conservatives clearly extend their majority (350+ seats) - A clear extension of the current majority would likely be seen as a positive and justify PM May’s decision to call the election. This was widely seen as the base case scenario once the election was announced but recent polls have raised doubts. This was seen as the most likely outcome when the election was announced and could be seen as GBP positive.
2) Conservatives fail to make significant gains but maintain majority (326-350 seats) - This outcome would see a comparable majority to that at present and would come as a disappointment to the Conservatives. The reason behind calling the early election was to improve their position by making substantial gains and a failure to do so would come as a blow and may see some of the gains in GBP since the announcement handed back.
3) Conservatives lose majority (<326 seats) - This scenario was deemed highly unlikely just a month ago but recent polls suggest that the Conservatives may actually end up losing seats which would see their majority eliminated. A hung parliament or a possible coalition of opposition parties would be a major blow to the conservatives and could see political infighting undermine the UK’s negotiating hand in Brexit talks. Would likely be seen as negative for GBP.
2017 UK Election - My Top Trade Ideas
The market reaction to the announcement of a general election shows that several markets are highly sensitive to this event. Here we present possible setups to watch out for over the election period and accompany them with both technical and fundamental rational.
Market : UK100
Likely market bias: Short
The UK100 has risen by more than 5% this year, with the last month accounting for all these gains. With the market close to an all time high of 7570 and entering a seasonally weaker period - See Sell-in-May report - there are plenty of reasons for a decline, however in the meantime, the UK100 remains in an uptrend so any short positions could carry risk in the medium term.
The election has the potential to provide a catalyst for a sell-off, either by a less than convincing Conservative victory (Scenario 2) or potentially with a buy-the-rumour-sell-the-fact move (Scenario 1), which would be reminiscent to the price action we recently saw in French markets following the 2nd round of the French Presidential election. Should the conservatives lose their majority (Scenario 3) the heightened uncertainty that would ensue could also weigh heavily on the stock market.
One signal that has worked fairly accurately in this market in catching sell-offs in the second quarter has been a death cross formation - when an 8 day exponential moving average (EMA) crosses down through a 21 day EMA. From 2010-2016 there have been 13 such observations. If a trader entered into a short position at the opening price the day after a death cross signal there was an average decline of 4.65%. Of course, if the market had rallied instead, there is a risk of a loss.
Here is an example of two death crosses when the 8 period EMA (blue line) crossed below the 21 period EMA (yellow line). Entering short positions at the open the next day would have seen declines in the market of 13% and 8%.
June is historically the most bearish month for the UK100 (FTSE 100 underlying)
The percentage return over the past decade is lowest in June, which has averaged a decline of 2.41%.
Furthermore, on eight of the last eleven occasions over this period, the market has posted a decline for the month of June. This could add weight to the short UK100 scenario should the election result be less than convincing.
Is the GBP and UK100 correlation breaking down?
Before we look at some FX pairs it is worth looking into the correlation between the UK100 and the GBP. The initial reaction to the election announcement saw the strong inverse relationship in the GBPUSD and UK100 hold with the former rallying and the latter falling. However in the days and weeks that followed we’ve seen the UK100 join in the move higher with both markets rising in tandem. This is an intriguing development as these markets have been strongly inversely correlated since the Brexit vote, with the pound hitting multi-decade lows and UK stocks posting record highs. A closer look at the composition of the UK100 reveals the reason for this as the majority of the index’s earnings are in currencies other than GBP. Therefore the bottom line is improved as these profits are translated into GBP terms and this provides a de facto boost to the share price.
There is currently a large divergence in the inverse relationship between the UK100 and GBPUSD. This correlation has been particularly strong since the Brexit vote but there has been a notable divergence since this election has been called.
If this correlation is to persist then we could expect a convergence between these two markets. That would require either the UK100 to decline or the GBPUSD to fall - Note the axis for the GBPUSD is inverted and therefore a fall in the pair would be shown as a rise on the chart.
Likely Market bias: Long
Along similar lines to the reasoning for potential short opportunities in the UK100, the case could be made for short positions in the GBP. Should either the victory for the Conservatives not be as convincing as they hoped it would be (Scenario 2) or they fail to even hold onto their majority (Scenario 3) there could be correlative weakness in the GBP. The Euro may be seen as one of the most attractive currencies to long against GBP given the recent rise in the single currency following the French elections and less dovish rhetoric from the ECB. From a technical perspective the EURGBP cross currently sits at a key level as price has recently broken out of a falling trendline taken from the high seen last October at 0.9252. In moving higher the market has also moved back above the 200 day SMA (yellow line) in what could be seen as a further indication as a change in the prevailing trend. Overhead resistance at 0.8785 is now not far from the market and any weakness in GBP around the election could see price break through here and move towards the 2016 high of 0.9252. On the other side 0.8300 has provided support on several occasions and is a key level to watch should this pair decline.
Likely Market bias: Long
The two scenarios presented so far would be more likely to occur in a disappointing outcome to the election from a market perspective. Our third and final trade idea is based on the election playing out in the most positive manner for GBP. If we get a strong result for the incumbent party and the GBP reacts positively then the GBPJPY pair could potentially offer the more attractive long opportunities. The GBPJPY was the biggest mover on the night of the Brexit and the market fell from 160 to a low of 123 by last October. Since then the recovery has been impressive but recent weeks have seen something of a pullback. During the latest rally the prior high from mid-December at 148.35 proved a step too far for price to breach, but a GBP positive outcome from the upcoming election could see the market recapture this level and move back towards the 1.60 handle.
UK Stocks to watch (SEE & Centrica)
Whilst the UK election has the potential to cause moves in the broader index, individual shares may offer excellent trading opportunities also. If we first look at a conservative victory as the base case scenario, the release of their manifesto reveals several policies which could impact UK - listed firms. The Tories are expected to dilute the threat to energy suppliers and tone down plans to cap utility bills ahead of a fresh review into the rising cost of Britain’s electricity. Since news of these caps broke there have been significant declines in SSE and Centrica (parent company of British Gas). The release of the conservative manifesto was warmly greeted by investors in these firms with notable rises seen on the day of the release (18th May).
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