Expect more volatility until general election is decided

GENERALLY the stock market has performed well in an election year, with 2001 the only recent exception. However, if the vote is perceived to be close then the market has tended to perform poorly in the period preceding the country going to the polls.

At this stage, based on the YouGov opinion polls, David Cameron will be the next prime minister and it is hard to believe that Gordon Brown and Labour will form the next government given the extent of the financial and economic crisis that has occurred during their watch.

The main concern for shareholders is the emergence of a hung parliament or coalition government with no single party having control of parliament. This may leave the economy vulnerable at a time when decisive leadership and legislation is needed to address the massive budget deficit, which is estimated to be 175 billion (or 12.4 per cent of GDP).

Following an inconclusive result, hard to swallow expenditure cuts, particularly in the public sector, may be placed on the back burner, increasing concerns about the UK's AAA credit rating. Consequently, the government's borrowing costs may increase at a time when gilt issuance rises as the quantitative easing programme, which has so far cost 200bn, comes to an end. Indeed, the process started in May last year when Standard & Poor's downgraded its view of the UK to "AAA negative" (from "AAA stable") for the first time since it began analysing the UK's public finances in 1978.

The most obvious casualties in this scenario would be sterling and gilt prices and it is disappointing that neither of the two main parties has clearly outlined plans for dealing with the budget deficit. Until the picture becomes clearer both gilt prices and sterling can be expected to remain more volatile than usual.

From its low point last spring, the stock market has risen dramatically, clearly anticipating financial and economic recovery, yet we are concerned that further advances could be stalled by political reluctance to address the national budget deficit. Should this be delayed for too long, there will be a requirement to raise taxes even more, and this could impact upon consumer demand.

Meanwhile, if sterling weakens this would cause inflationary pressures to build. A combination of lower growth and possible inflation is an unpalatable prospect, and so the next chancellor will be walking a tightrope which could easily become a plank if policy errors are made.

The negative implications of UK economic policy on shareholders are, therefore, fairly obvious but it is worth remembering that a number of FTSE 100 companies earn a significant proportion of their earnings overseas, meaning the likes of Rio Tinto, Diageo, GlaxoSmithKline, Vodafone, BP and Royal Dutch Shell will be more influenced by events on the international stage. Typically these company names are viewed as being "defensive" with relatively secure dividends and worth holding.

A May election would see Alistair Darling announcing a Budget in March. However, it is difficult to believe this would contain anything of substance, with government finances in such a parlous state and an election around the corner. The real event is likely to be the announcement of an emergency Budget by the new government.

In terms of expenditure cuts, the Ministry of Defence budget is being seen as under intense pressure, so expect a Strategic Defence Review.

On the other hand, BAE Systems has seen its shares recover a small part of the ground lost last year as the market appreciates the long-term nature of the major programmes in its order book and the penalties a future government would have to pay for cancelling or delaying these.

Indeed, the recent awarding of contracts worth 330 million relating to two aircraft carriers would indicate that there is still a commitment to defence projects. In this environment a degree of caution is needed over the strength of the order book, but for the time being the shares appear to offer a degree of value.

Construction is another area of the market likely to be vulnerable to government cuts, with concerns that key infrastructure projects, particularly in transportation, power and education, will be delayed or cancelled. As a result, the share price of, for example, Balfour Beatty has been under pressure. However, shares in this company are interesting given the steps it has taken to diversify its business interests away from the UK in recent years.

Capital gains tax, currently charged at 18 per cent, is an obvious candidate for change. Therefore, any fundraising exercise that will incur a CGT liability should be carried out in this tax year.

As for savers, it may be that new schemes will be introduced or existing schemes amended. However, Individual Savings Accounts (ISAs) have proved hugely popular since their introduction in the late 1990s. Where possible, full advantage should be taken of the Isa allowances.

That said, I wouldn't count on tax giveaways, despite Conservative "plans" to abolish all tax on savings income for basic rate taxpayers, "making them up to 7,200 a year better off".

Exactly when such a policy is likely to be enacted has still to be clarified. Given the dire state of the public finances, such a concession seems unlikely in the short term.

Charles Robertson is senior investment manager with Murray Asset Management