The FTSE100 index has recently touched its all time high. Is this peak justified? Most likely not, in our opinion. There are both long term and short-term reasons to expect the most important UK index to decline in the near future.
Long Term: global economic growth and interest rates
Let’s first address the reasons why the index may, at the moment, be trading above its long term fundamentals. Under this point of view, we must note that the FTSE100, despite being an equity index of companies based in the UK, is heavily exposed to exports and consequently to the global economic situation. As a matter of fact, most of the components of the index are huge multinational companies with a big chunk of their revenues raised abroad. Global economic growth has slowed down in the last year, with the notable exception of India. Yet, India’s positive contribution to growth in Emerging Markets is not probably going to be enough to offset China’s slowdown. The likely turmoil Emerging Markets will experience later this year, when the Fed will eventually hike interest rates, is going to boost uncertainty. Moreover, according to us, the Chinese economy may be performing much worse than what official data would lead us to believe. Debt overhang, a property bubble and a deregulated and opaque financial system might suddenly appear, especially as concerns about growth get stronger. Both the government, with a larger than expected deficit, and the Central Bank (PBoC), by lowering its interest rate and RRR(Reserve Requirement Ratio), are stimulating the economy in order to counter the slowdown. Yet, our opinion is that in this macroeconomic environment Chinese imbalances will eventually emerge.
UK biggest trading partner, the EU, has just launched its QE programme that quickly depreciated Euro by about 15% with respect to the pound. This, again, will result in reduced revenues abroad and less competitiveness.
A second long term issue lies in interest rates. The BoE is still keeping its short term interest rate at a historical low of 0.5%. Even though we are not entirely sure when, it is likely that the MPC will eventually start hiking rates, as well as reducing the asset purchase programme. The market is currently pricing some likelihood of a rate hike since late this year. Two members of the MPC voted in favour of higher interest rates in late 2014, but lower inflation realigned their views with that of Carney. We believe that the deflationary pressure of lower oil prices has already been transmitted in prices and that, with such a low unemployment rate (5.5%), inflation is likely to bounce back in the medium term.
Equities and interest rates usually have a negative relationship: a UK rate rise will probably deflate stock prices. Furthermore, higher interest rates will cause the pound to appreciate penalizing exporters even more.
All these considerations are focused on long term, but we know that markets can diverge from fundamentals for a long time. As Keynes once put it: “Markets can remain irrational longer than you can remain solvent.”
Short term: UK elections
Yet, we might have a short term catalyst that is working in the same direction of fundamentals: the UK elections, taking place the 7th of May. The two main parties, Labour and Conservatives, are increasingly close to each other in polls and neither TV debate between Cameron and Miliband nor their parties political manifestos managed to change the balance in favour of either of them. Furthermore, a strong SNP (Scottish National Party) has eroded both parties consensus by gaining seats in Scotland. This amplified the gap needed to obtain a majority in the lower House of Parliament. The last projections of the allocation of seats in the House of Commons are represented in the following chart.
Were these forecasts reliable, we would have a hung parliament, with no single party able to obtain an absolute majority in the House of Commons. Other projections differ slightly, attributing relative majority to the Labour Party and not to Conservatives. Yet, we will see why this does not change the outcome of our analysis.
Lib-Dems are likely to be part of any government that will emerge, as they opened up to both Conservatives and Labourists during the presentation of their manifesto. Accordingly, we can revise down the number of seats needed to govern from 325 to 300 by assuming that Lib-Dems will be part of any new government. However, such a strong SNP representation poses a serious threat to governability. Miliband pledged not to form a coalition with the SNP after the elections, and conservatives have historically been politically opposed to the SNP. Without their 46 seats, it would be really difficult to obtain a majority, even under the assumption that Lib-Dems will back any coalition able to govern.
We can now see why these elections are likely to result in a hung parliament and, consequently in high uncertainty. We know that businesses, corporations and especially markets dislike uncertainty.
Yet, there is something that both businesses and markets may dislike even more: Labours and Conservative economic agenda. Labour pledged to increase taxes on high earners and big corporations, in order to reduce UK deficit. Conservatives instead want to propose a referendum on the exit from the European Union, which may cause the decline of the “City” in favour of Frankfurt as European leading financial centre. So, even in the unlikely event of a clear-cut majority emerging after the elections, policies endangering long term growth are a key part of the political manifesto of almost all the incumbents.
Taking all these factors into account, we want to take a short position in the UK leading index: the FTSE100.
There are different ways to take this position from shorting the underlying to agreeing to take a short position in a forward or even using options. While the former two are straightforward and merely allow to trade the underlying, the latter may be slightly more complex.
For what concerns the lasts, the position should be taken in short term options, by buying either one or two months puts. In case we wanted to make a bet on a sudden decline in the option price following the election results, probably a 1 month out of the money option would be appropriate. We could either keep it to maturity, or very close to it, focusing as in the previous case on the change in the underlying price. An out of the money option is preferred to exploit some “gearing”. Deep out of the money options are not appropriate, as neither a huge correction is expected nor the option time horizon allows for a long term correction in the underlying price. The advantage with respect to using a short forward would be both the “gearing” of the option and the limited downside. The price for these desirable features is the premium you pay up front, which is quite high right now. The premium can be “measured” in terms of implied volatility. The following chart represents how the VFTSE, a index tracking implied volatility on FTSE100, moved in the last week.
The two months option would also allow to trade, in addition to spot price change, the 1 month volatility the market expects one month from now. This choice would be optimal for an investor who believes that it will turn out to be extremely difficult to find a majority in the parliament resulting in high uncertainty (and consequently volatility) even one month from now. One caveat for using this strategy is that the implied volatility is already high (ie. Markets are already pricing uncertainty following elections), and to profit from the elections an extremely difficult situation must emerge. At the money options (or some slightly out of the money) should be used, as their Vega is maximum.
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