Stockwatch: Politics, tax and contrarian plays

Is Morgan Stanley justified to warn of a general election as early as 2018, a Labour victory being more damaging to business than Brexit? Certainly, if the Tories continue to tear themselves apart, EU negotiations distract from domestic initiatives and the economy turns down.

The track record of Labour versus Conservative governments since 1970 shows the London stockmarket returning an average 16% annually under Conservative rule and 9% under Labour. Meanwhile, company earnings having grown an average 11% a year under the Conservatives versus 6% under Labour.

Yet with Corbyn’s party presenting the chance of a far more radical re-set of policy, what’s the real upshot?

Re-nationalisation talk is likely hot air

Most privatised utilities no longer exist as separate entities, merged instead into wider groups or under foreign control – e.g. Thames Water owned by Kemble Water and Northumbrian Water by Cheung Kong Infrastructure Holdings.

In water supply there’s hardly anything left exposed to direct nationalisation beyond Pennon Group (PNN), the old South West Water group which trades on a forward price/earnings (PE) ratio in the mid-teens, yielding 5.1% prospectively.

Rail and bus operations are held within the likes of FirstGroup (FGP) and Stagecoach Group (SGC), but would need a complex unpicking. Quite from where a Labour government would get money to buy back British Gas from Centrica (CNA) or the UK operations of BT Group (BT.A), which constitute 81% of revenues of this £24.7 billion giant, unless pursuing a socialist asset-grab that turns Britain into Venezuela and kills off foreign investment.

Brexit already shows pragmatism prevails

As a reality check, the Leave EU campaign focused on regaining control of £350 million a week sent to Brussels, saying Britain could walk out of trade talks and revert to World Trade Organisation terms. This remains the critique by Nigel Farage and backbencher John Redwood MP.

Yet, note how in government and with business lobbying hard, especially the car industry, Boris Johnson has shifted ground to say: “50 billion euros is a fair offer to the EU…let’s get this ship off the rocks and secure a trade deal”.

Similarly, Labour would hit realities with its own ideology. In re-nationalisations, “Compensation will be on terms agreed by parliament” says John McDonnell, i.e. not market value.

It’s cloud cuckoo land for a modern international economy, the same way Brexiteers claimed it would be possible to leave the EU and continue trading pretty much as before.

Might useful dividend yields follow in due course?

In principle, stocks at risk will de-rate to offer yields juicy enough to tempt investors notwithstanding re-nationalisation. In practice, many have achieved this without help from Corbyn/McDonnell.

At about 250p, BT trades at a two-year low, yielding 6.5% covered 1.8 times, broadly because competition has turned BT’s monopoly into a steadily eroding oligopoly, e.g. Ofcom’s insistence on separating Openreach.

At 143p, Centrica is at a four-year low and yielding 8.4% if the dividend (covered once by earnings, possibly more by cash flow) is held – largely because British Gas has sat complacently with a huge customer base on an over-priced standard tariff. Finally, they are moving on Centrica profits are collapsing.

Both examples reflect hangover issues from past nationalised monopolies that privatisation was intended to shake up.

At 430p Royal Mail (RMG) seems to be going nowhere as competition in parcels intensifies and online kills off letters: a flat profits’ outlook priced for a 6% yield.

At 180p, Stagecoach is at a two-year low and yielding 6.6%, about 1.5 times covered by forecast earnings. Shareholders are down over 50% on market value in 2014 and 2015. Such privatised industries already offer dull prospects so are priced for yield.

Outsourcers, defence and retail under the cosh

Outsourcing has hit diminishing returns after this trend has spawned many operators, then run into government austerity. The most glaring example is Babcock International (BAB) in diversified outsourcing services, which includes defence contracts.

Its stock is currently in a four-year bear market, down from about 1,300p to 664p recently. Now 700p, it trades on a forward PE of 9 and a 4.2% yield covered over twice by earnings and more so by cash flow. It’s a guessing game whether sentiment is jaundiced or fair in respect of the risks.

Meanwhile, retailers are in a dilemma of being low-margin and more likely to employ staff on the minimum wage; thus, a Labour government raising it would also raise the hurdle for profits also.

More positively if such stocks remain under pressure, they are liable to over-shoot on the downside so are of potential interest to contrarians.

Labour may win but only in minority government

It’s possible the Tories stumble on to May 2022, albeit with Brexit involving more cost than benefit in this period and the electorate increasingly tired. “Vote Corbyn” will be seen as a means to a radical re-set, especially among younger voters locked out of asset ownership achieved by their parents and facing little prospect of real wage growth.

Moreover, the Conservatives’ challenge to win a third term in office is similar to US Democrats’ dilemma in 2016, despite Donald Trump lampooned as a bigoted narcissist. Punters who bet successfully on the Republicans did so from historical evidence the public mood shifts from incumbents.

All Labour effectively has to do is come across as credible to govern; yet the radical Momentum faction is now mainstream within the party and Corbyn will be 73 years old in April 2022. So, according to how effective is the Conservative campaigning, there’s still a likelihood British political moderation will prevail overall, i.e. if a Labour government happens then in minority form.

History implies “macro matters” before UK politics

A Labour minority government from February to October 1974 saw a near 50% fall in the stockmarket – albeit after a shock oil price rise – with the market PE multiple falling below four times.

A second minority Labour government then coincided with equities nearly quadrupling over the next five years, which interestingly coincided with penal rates of wealth taxation and soaring inflation.

That shows how equities can be a useful hedge, assuming those companies have relative freedom to price goods/services.

From 1979, the next 18 years under the Conservatives saw investors enjoy 20-fold overall gains despite the 1987 market crash, albeit the humiliation of sterling exiting the European exchange rate mechanism in 1992 and an early 1990s recession.

This rollercoaster was broadly matched in international markets, however. Similarly, the 1997 to 2000 period was greatly influenced by the dotcom bubble, then the 2001 attack on the World Trade Centre and subsequent Iraq war.

London also marched with other markets from 2003 to 2007 until the US sub-prime fiasco; the subsequent Tory/Lib Dem coalition government saw little real growth in company profits although global equities rose on the back of central bank stimulus.

So, there should be no problem exacting returns from FTSE 100 (UKX) and Mid 250 (MCX) listed overseas earners, if the international context allows.

A chief area of risk is UK-oriented small caps -those that have soared in a mature bull market -as shown by the recent savaging of AIM-listed shares in luxury interiors’ group Walker Greenbank (WGB).

Higher taxation of unearned income looks due

New Labour was shareholder friendly in some respects -e.g. accelerated taper relief on unlisted shares making some tax-free on AIM -but ran into public spending issues such that taper relief was abolished in April 2008, since when the Conservatives’ “reform” of dividend taxation has meant lower returns for most people holding equities outside a tax-free wrapper.

The context shows both parties constrained by public debt, thus grinding down on shareholders as an easy target, although unearned income seems a particularly visceral target for socialists.

Recalling the 1970’s, certain categories of it were taxed up to 98%, whereas a significant rise in capital gains tax would be self-defeating e.g. for productivity now Britain is highly dependent on foreign investment.

The obvious action, where possible, is to ensure savings go into a tax-free wrapper, utilising annual allowances, as it will be hard for Labour to tear up the contractual basis for ISAs and SIPPs.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.