Events Trader #25: How to profit from the general election

27th October 2009

• How to profit from the general election
• Time to close our Vix trade

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This week, I'm getting a bit political. As you're probably aware by now, there's an election due in the UK around next May and I'd like to look at how we can make money out of it.

We'll also be closing one of our open trades, and updating on some of our favourite stories, including National Express and the situation in Latvia. So it's a busy week let's dive straight in.

Cashing in on the "Tory trade"

A general election must be held in the UK no later than 3 June next year, and most people reckon it'll happen on 6 May to coincide with the local elections scheduled for that date.

At the moment, it's looking very likely that Labour's 13 years in power will come to an end. That could mean a very significant shift in policies in various different areas (hopefully, it'll also help Gordon Brown realise that Britain and the rest of the world can cope without him!)

So I want to look at how we can profit from "the Tory trade". This is simple. It's just about making money from whichever sectors of the market and economy stand to benefit from a Conservative party victory.

It's not an original idea - it was created in the US a long time ago. The "Republican" and "Democrat" trades are popular strategies, widely used when a change of power is on the cards. The "Republican trade" for example, often means buying defence stocks and oil explorers, as high defence spending and energy self-sufficiency are two of the right-wing party's cornerstones. Remember the debate about opening up the Arctic for oil and gas exploration?

A typical "Democrat trade" on the other hand would involve shorting the pharmaceutical and healthcare sector you'll no doubt be aware of the proposed healthcare reforms that President Barack Obama is just now trying to push through Congress.

Now, so far in the UK, no party has come out with a manifesto, so it's hard to get a precise view on proposed changes. However, I think we can still draw some interesting conclusions from this exercise.

Which themes should you focus on?

The first and most important point - as you can imagine - is the economy and the state of public finances. Here the Conservatives are seen as the party of fiscal responsibility, which will sort out the disastrous budget deficit left by Labour. This suggests to me that if the Tories win, the pound could rally quite substantially, possibly towards $1.80-1.85, and €1.20-1.25.

This is likely to have a knock-on impact on companies which benefited from the cheap pound, such as British Airways, Vodafone, BP or Rolls Royce for example. These could take a hit, because most of their revenues are in dollars, but their costs are in pounds.

The second area where we could see a change is in Private Finance Initiative (PFI) projects. These are public projects financed with private capital, which has the effect of shifting the debt off the public sector's balance sheet. PFI was introduced by the Labour government, but has proved highly controversial because such projects have proved very costly for the taxpayer. So it's likely that these agreement might be reviewed and new initiatives may turn out to be less profitable than the existing ones. Among the most exposed stocks in this case would be support services group Carillion (LSE: CLLN).

There's a third area where I can see changes. A minimum price for alcoholic drinks might be imposed, while supermarket promotions might be banned. This could be a popular move it could raise revenues and improve health, but most of all it would support the pubs and leisure sector, which has been hit by falling sales and a string of bankruptcies and pub closures. In this case, you should focus on pub owners rather than brewers.

What if there's a hung parliament?

If the Tories fail to win enough seats for an overall majority they might be forced into a coalition government with the Liberal Democrats or the Scottish Nationalists. This would be a worse outcome as the political parties would be forced to compromise on various issues.

However, the three themes we have identified should still hold true. The Lib Dems are likely to be take quite a tough line on the public finances, and if they were to form a cabinet we might have the highly regarded Vince Cable as Chancellor, which could further improve sentiment on the pound.

As for the Scottish Nationalists, I'm sure the Tories will be happy to support independence for Scotland - as long as they take their banks with them! Joking aside (my editor's Scottish so I'm taking my life in my hands here), SNP leader Alex Salmond has already said he'd be happy to join a coalition government providing he could get lots of perks for Scotland.

Strategy

For now it's still too early to take any positions. The risk that the market could correct is still too great and this could outweigh any potential gains from the "Tory trade". Also, no party has published its election manifesto yet. Once more policies have been revealed, we'll review the situation and generate more trading ideas.

By the way, just before we move on, let me make clear that as a foreigner, I have no affiliation to any British political party. However, I do think we should replace Gordon Brown and Mervin King both men in my view, bear a lot of responsibility for the current mess we're in. Both failed to spot the dangers of a bubble in credit creation driving up asset prices (real estate in particular), yet they had plenty of past experiences to draw on (Germany 1990-2003, Hong Kong 1997-2004, and Japan 1989-2005, to mention but a few).

King is guilty of using old tools to try to mend a crisis, which instead requires much more radical thinking. Interest rates at 0.25% cannot increase lending or help the economy get through a crisis that was caused by excess lending. They only act as a tax on savers and prudent individuals and subsidize those who behaved recklessly. In my view he is also guilty of a more important sin. He has already used all the fire power he could muster, which means now we don't have any ammunition left if we have to deal with a second crisis. If you were a soldier, I don't think you'd want to be led by generals who behaved like that.

Time to cut our losses on our VXX trade

October is drawing to a close and the surge in volatility that I was expecting back in August has not materialized. So I think we should close our VXX trade, which stands at $43.70. Unfortunately the strategy hasn't worked out, and now that we're heading into pre-Christmas trading I don't expect volatility to increase significantly. So let's cut our losses and get out.

Recommendation: SELL iPath S&P 500 VIX Short-term Futures ETN (NYSE: VXX).

The latest on Sun Microsystems

Moving on to other topics - Sun Micro (US: JAVA) fell 7% last week to $8.50 after a meeting between Oracle's European president Safra Catz and European Commissioner Neelie Kroes failed to produce an agreement on the proposed merger of the two companies. Kroes complained that Oracle had "failed to produce hard evidence that there were no competition problems or a proposal for a remedy to the competition concerns".

The meeting revolved around the MySQL open source database. I can understand why Oracle doesn't want to spin it off. MySQL represents just $20m in revenues for Sun Micro and being open source it cannot be killed off, even if Oracle wanted to, because anyone can use the code which is not protected by copyright. We've had price swings before in Sun and I think this is no different the issue can be resolved, and it probably will be in future meetings.

My advice is to stay long and increase your position to reduce the average price. If the stock rebounds to $9.10-9.20, you can then sell back what you have bought down here.

and updates on some of our other trades

Meanwhile, drugs group Merck reported its first quarter results last week. Turnover shrank and Merck's guidance for 2010 was reduced. The group also stated that its merger with Schering Plough remains on track to close this quarter, but no date was given. The bank syndication facility is now in place and that the relevant antitrust (competition law) filings have been submitted.

National Express also issued a third quarter trading update. The transport group said that trading conditions remain "challenging" with turnover falling by 1% and net debt up by £30m due to seasonal factors. The group is also still negotiating with the government over its rail franchises. The most important thing however is that lenders agreed to extend the maturity of 50% of the group's debt facilities which are due to expire in September 2010 to March 2011 if the company undergoes an equity raising.

This means that once the equity raising is done, the company should be financially sound, but it will still have the uncertainty surrounding the eventual fate of the UK rail franchises. Let's now wait for further details of the rights issue and the merger with Stagecoach. I m sure we'll be revisiting this story in the next few weeks.

Document management group Xerox also announced results for the third quarter, but no update on its merger with Affiliated Computer Services was provided.

What's going on in Latvia?

Let's now quickly revisit one of the stories we had a look at over the summer Latvia and its economic problems (you can read the original piece in the Events Trader archive, issue 10. Password: Decision). Since the summer the situation in the country seems to have stabilized and talk of devaluation has somewhat receded. An $11bn bailout has been organized and Swedish banks - the most exposed to the Baltic states - have managed to raise extra capital.

The best news so far is that the country is now running a current account surplus of nearly 15% of GDP (it was a 10% deficit previously) and after an 18% decline in GDP this year the economy is expected to start growing again from late 2010. Wages and prices have also fallen sharply.

The problem however lies with the government's inability to make deep budget cuts that would bring the budget deficit down to 8.5% of GDP next year, and to reform the public sector (a problem that we're familiar with in the UK). Next week, after a long parliamentary battle, the government is expected to approve a budget that will cut spending by 320m lati ($680m) and will raise revenues by 180m lati ($380m).

However, a devaluation is still on the cards as further budget cuts will be hard to push through. And if the economy doesn't recover soon, it will add further pressure to the budget deficit. So far it still looks as though a rerun of the Argentinian crisis of 2001 isn't out of the question, and in that case, we could see a domino effect that would infect other weak eastern European countries (such as Estonia, Lithuania, Bulgaria, Romania, Ukraine and Hungary). That could easily be the catalyst that ends the rally that we've witnessed in the past few months.

As usual I welcome your e-mails - you can write to me at eventstrader@f-s-p.co.uk.

Riccardo Marzi

Events Trader

Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Some shares recommended may be denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.

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