BLACKROCK INVESTMENT INSTITUTE

RULING BRITANNIA UK 2015 ELECTION PREVIEW

MARCH 2015

[ 2 ] R U L I N G B R I TA N N I A

SummaryThe UK faces its most uncertain election in a generation. The electorate’s declining appetite for traditional parties – the ruling Conservatives and centre-left Labour – means the race is unlikely to produce a majority winner.

Who will rule Britannia – and what would this mean? We debated post-election scenarios and their implications for UK fiscal policy and asset prices, taking a deliberately apolitical view. Our main conclusions:

}Opinion polls and betting sites suggest the most likely outcome is a weak coalition government: a Labour-led coalition with informal support from the Scottish National Party (SNP) or a less stable repeat of the current alliance between Conservatives and Liberal Democrats.

}A loss of support for major parties, the peculiarities of the UK’s ‘first-past-the-post’ constituency system and the rarity of political coalitions mean it could take several weeks or more to establish a new government. This would be business as usual in the rest of Europe, but it is unusual and somewhat harrowing for the UK.

}A Labour-led government reliant on SNP support for key votes would raise the spectre of a disunited kingdom. Imagine a similar situation in Spain if the central government were dependent on Basque or Catalan separatists, or a Canada beholden to the Parti Québécois.

}A soothing outcome for markets is hard to imagine. Labour would be tough on business – and might be perceived as lacking fiscal responsibility. A Conservatives-dominated cabinet would pave the way for an unsettling referendum in 2017 on the UK’s European Union (EU) membership. Whoever wins – and the result could take time to emerge – will lead a weak government likely to pass only watered-down legislation.

}UK markets have been relatively calm, suggesting a smooth and swift government handover. We believe this view is too complacent – and expect volatility in the currency and other UK assets. Retaining international investor confidence is key: gaping current account and budget deficits make the UK particularly reliant on the kindness of strangers for financing.

}The main financial challenge for any new government will be cutting the budget deficit. The major parties mostly agree on the direction of adjustment but disagree on how to get there. Conservatives prefer spending cuts to tax hikes, while a Labour-led coalition would likely cut the deficit at a slower pace. The SNP, by contrast, favours more generous welfare and health spending. The problem? Weak productivity growth undermines the success of any fiscal plan.

}Backtracking on the pace of deficit reduction would likely lead to a temporary sell-off in gilts and steepen the yield curve. It could also result in a rise in inflation expectations and bring forward the timing of interest rate hikes. Yet we do not see a lasting election impact on UK fixed income assets. Issuance of gilts is set to fall as the UK deficit shrinks – and a steady bid from pension schemes and other long-term asset owners should dampen any yield spikes.

}UK equities and corporate credits could perform poorly because new governments tend to front-load austerity measures, denting consumer confidence. A Labour-led coalition would threaten the profitability of highly regulated industries such as banking (higher bank levies, more competition) and utilities (pressure to lower energy bills). Housing-related equities look attractive due to both major parties’ support for the industry.

Joe Di Censo Portfolio Manager, BlackRock Global Fixed Income

Luke Chappell Co-Head of BlackRock’s UK Equity Team

Ewen Cameron Watt Global Chief Investment Strategist, BlackRock Investment Institute

Arno Kitts Head of BlackRock’s UK Institutional Business

Paul Bucksey Head of BlackRock’s UK Defined Contribution Business

Tony Stenning (not pictured) Head of BlackRock’s UK Retail Business

The opinions expressed are as of March 2015 and may change as subsequent conditions vary.

What is insidePolitics ...........................................3–4Policy ...............................................5–6Taxes and cuts .......................... 7–8Investments ............................. 9–11

U K 2 0 15 E L E C T I O N P R E V I E W [ 3 ]

PoliticsThe UK election on 7 May is set to be closely contested. Polls and bookies point to a neck-and-neck race between Conservatives and Labour, with both expected to attract about one-third of the popular vote. The SNP looks to become the third force in UK politics – unusual for a regional party with an avowed aim of separation. (The closest precedent would be the Irish nationalists’ holding the balance of power after the 1885 election.)

Each of the UK’s 650 electoral districts, or constituencies, will elect one member of parliament (MP) for five years in the House of Commons. The five key players:

}The centre-right Conservative Party, led by Prime Minister David Cameron, holds 302 of the 650 available seats. It formed a coalition with the Liberal Democrats after falling short of a majority in 2010.

}The centre-left Labour Party commands 256 seats. It favours a tougher stance on business (freezing utility tariffs and raising levies) and higher taxes.

}The SNP led the unsuccessful campaign for Scottish independence in a 2014 referendum. Support for the SNP in Scotland has almost doubled from the 20% share of the vote won in 2010, at the expense of Labour

}The Liberal Democrats currently are the UK’s third party with 56 seats. The Conservatives’ coalition partner has seen its popular support plunge to just 7%, polls show.

}The populist UK Independence Party (UKIP) has made big gains since 2012, boosting its popularity to around 15%. UKIP won no seats in 2010 but has since captured two seats thanks to Conservative defections.

DEATH OF SINGLE-PARTY POLITICS The rise of smaller parties means the betting is heavily on a coalition government, bookmakers show. The main scenarios are a Labour-led coalition with informal support from the SNP or a repeat of the current alliance between Conservatives and Liberal Democrats.

Yet there are many permutations: the UK’s ‘first-past-the-post’ electoral system ensures the party with the most votes in each constituency wins – even if it fails to get a majority. The result? Popular support for smaller parties often does not translate into the number of seats won. The Liberal Democrats won 23% of the vote in 2010, but captured just 9% of the seats in the House of Commons. A similar fate may await UKIP this time around.

BRACING FOR BREXIT A referendum over the UK’s EU membership is a key risk under a Conservative majority or a Conservative-led coalition. Labour would likely only offer a referendum in case of changes to the EU Treaty in the years ahead. Polls show the British are leaning toward a ‘stay’ vote, but the proportion in favour of leaving the EU has exceeded 50% at times. See the chart below.

A 65-35 majority wants to stay if the UK’s membership can be renegotiated on more favourable terms, polls show. Immigration and the ability of EU migrants to access the UK’s welfare system are key sticking points. Yet changes to the EU Treaty would not come easily (other member nations are wary of new negotiations).

A 2017 referendum is far from a foregone conclusion – and neither is a vote to leave the EU. Yet the spectre of British exit highlights potential downside risks of such a move: sovereign ratings downgrades, an erosion  of the safe-haven status of gilts, a dampening of business and foreign investment, and a harsh spotlight on the UK’s chronic current account deficit. Expect markets to be roiled if a ‘Brexit’ becomes a real possibility.

LEAVING IS HARD TO DOOpinion polls on UK EU, 2011-2015

30

35

40

45

50%

20152014201320122011

Stay in EU

Leave EU

SH

AR

E O

F R

ES

PO

NS

ES

Source: BlackRock Investment Institute and YouGov, February 2015.Note: responses are based on the question “If there was a referendum on Britain’s membership of the European Union, how would you vote?”

“ We should encourage a savings culture, both to better prepare people for retirement and to boost investment in Britain.”

– Joanna CoundHead,

BlackRock Public Policy Europe

[ 4 ] R U L I N G B R I TA N N I A

HUNG OUT TO DRY?The electoral system favours the SNP. The party has little national appeal (it does not contest seats outside of Scotland) but has concentrated support at home. Polls point to the SNP winning up to 50 seats, versus six at present. This decreases the chance of one party obtaining a majority in a legislature where 326 is the theoretical majority.

Post-election horse trading could drag on longer than usual. Party chiefs have learnt the lessons of the 2010 election. (The Liberal Democrats caved in on many of their policy promises, only to see their popularity plunge.) In addition, SNP involvement in any coalition would be contentious – and could antagonise English, Welsh and Northern Irish voters. Conservatives would likely face more stringent opposition from their own MPs disappointed by the 2010 coalition deal.

Coalition haggling is usual in the rest of Europe, as are caretaker governments. Belgium did just fine for about 600 days with a caretaker government in 2010-2011. It is a different story for the UK. Markets are used to – and expect - swift government handovers in the UK, notwithstanding the ostensibly adversarial nature of British politics.

THE SCOTTISH QUESTIONWhichever combination emerges, the new administration could preside over a constitutional crisis due to the SNP cohort at Westminster. We expect sizeable opposition in the rest of the UK to a separatist party voting on UK issues without a reciprocal arrangement in Scotland. The debate will likely centre on reforms such as excluding Scottish MPs from voting on English-only issues.

Scottish Parliamentary elections in May 2016 could raise the spectre of another Scottish independence referendum. The fall in oil prices, however, has dealt a blow to Scottish revenues and illustrated the benefits of being part of a larger fiscal union. Presumably, the SNP would not want to actually deliver on Edinburgh’s nickname of ‘the Athens of the North.’ We expect devolution for now, rather than separation.

Differences on public spending priorities could raise the constitutional stakes in a fractious parliament. The SNP favours an expansive approach to public spending, raising the prospects of increased government handouts and an even greater divide in regional benefits.

Imagine a world where the SNP (and other regional parties) obtain more power over spending and borrowing in return for support on key votes. This could turn the UK into a sort of pre-crisis Spain, with mounting piles of regional debt to fund local spending. When fiscal stress hits, markets would look to the sovereign to bail out regional borrowers.

UNCERTAINTY IS CERTAINBritain’s unwritten ‘constitution’ offers no guidance on messy election outcomes, and precedents are few. Only a political leader confident of passing a legislative programme in the House of Commons will receive an invitation from Buckingham Palace to form a government.

If coalition talks fail, parliament could be dissolved and a snap election called. This would lead to an extended period of political uncertainty. It is theoretically possible but practically unlikely. Legislation written in 2011 stipulates circumstances for a second election. This includes a failure by one party to form a government and a second party also failing after a further 14 days.

Any minority government faces the prospect of being in office but not in power (barring the unlikely outcome of a grand coalition between Conservatives and Labour). This heralds compromises that could gum up the legislative process. Conclusion: forming a coalition will be difficult and the possibility of a weak and unstable government is high. The UK will start to look more, not less, European.

What does this mean for markets? Credit default swap spreads have been pretty stable, suggesting little political risk has been priced in. Implied three-month volatility in sterling, however, has spiked – just as it did ahead of the 2010 UK election and the 2014 Scottish referendum. Even more telling: relative sterling volatility (adjusted for currency market gyrations such as the effect of the slumping euro) recently exceeded levels reached ahead of major political events in the 2000s, Barclays research shows. See the chart below. We expect volatility to stay high.

PRE-ELECTION JITTERSRelative three-month sterling implied volatility, 2001-2015

0

0.25

0.5

0.75

1

2005election

2001election

AverageScottishvote

2010election

2015election

RE

LATI

VE V

OLA

TILI

TY

Sources: BlackRock Investment Institute, Barclays and Bloomberg, March 2015. Notes: the relative volatility is the average three-month implied volatility in sterling crosses with the US dollar and euro divided by the average volatility in US dollar crosses with the euro, yen, Australian and Canadian dollars 37 trading days prior to the 2001, 2005, 2010, 2015 elections and the 2014 Scottish referendum. Data as of 18 March 2015.

U K 2 0 15 E L E C T I O N P R E V I E W [ 5 ]

PolicyThe biggest challenge for any new UK government will be reducing the country’s bulging budget deficit. The twin deficit – the combined fiscal and current account shortfall – amounts to almost 8% of GDP, the largest in the G7. See the chart below. This means the UK is reliant on the kindness of strangers (foreign creditors) to finance its spending.

Yet the UK is a middling performer in our BlackRock Sovereign Risk Index (BSRI), ranking 19th out of 50 countries. Willingness to pay – our measure of government effectiveness and rule of law – is the UK’s strong suit. Fiscal space – our gauge of a nation’s debt levels and financing vulnerability – is the country’s Achilles’ heel. The UK lags behind Germany and the US on this measure – but ahead of France, Italy and Japan. See the chart to the right. The country’s fiscal outlook is improving. Expectations of the budget deficit (twelve months forward) stand at just over 4% of GDP today, versus more than 12% in mid-2009, according to consensus estimates.

What are the chances that a new government changes these dynamics? Small, we think. The major parties have pledged to eliminate the structural (non-cyclical) budget deficit over a three-year rolling period – and to bring the overall budget into balance by 2020. If you have a current account shortfall, addressing a fiscal deficit matters.

THE RIGHT MIX The major point of disagreement is not the amount of fiscal discipline – but the mix. Conservatives plan to focus almost exclusively on spending cuts to hit deficit reduction targets. Labour sees a 50/50 split between belt tightening and tax hikes. See the table on the next page and the following chapter for details.

Yet coalition politics could throw a spanner into the works. The SNP, for example, aims to boost public spending (likely funded through increased borrowing and tax hikes). If a Labour government were to rely on SNP support, markets may question its fiscal discipline. This would likely lead to sell-offs in gilts and sterling.

Any slowing in the pace of fiscal consolidation could support the UK economy – and likely lead to a rise in inflation expectations. This could spur the Bank of England (BoE) into raising rates faster than markets currently expect, all else being equal. The disinflationary impact of cheaper energy, tepid wage growth and a weak eurozone economy have kept it on hold. Core inflation has been declining since 2011, although there are recent signs of a pickup in UK wage growth.

WORST IN CLASSG7 government and current account balances, 2015

-8

-4

0

4

8%

SH

AR

E O

F G

DP

Structuralbudget

balance

Currentaccountbalance

DE IT FR CA JP US UK

Sources: BlackRock Investment Institute and IMF World Economic Outlook, February 2015.

MIDDLE OF THE PACKG7 BlackRock Sovereign Risk Index comparison

-1

-0.5

0

0.5

1

BS

RI S

CO

RE

Externalfinance

Fiscal space

Willingnessto pay

Financialsector health

Overall

DE CA US UK FR JP IT

Source: BlackRock Investment Institute, February 2015.Notes: the chart shows the score breakdown of the G7 countries within our BlackRock Sovereign Risk Index (BSRI). Drawing on a pool of more than 30 quantitative measures spanning financial data, surveys and political insights, the BSRI provides investors with a framework for tracking sovereign credit risk in 50 countries.

“ Things are on the up. The UK’s fiscal profile has been improving, banks are healthier and its institutions are respected by the market place.”

– Garth FlanneryPortfolio Manager,

BlackRock Model-Based Fixed Income

Click for interactive data

[ 6 ] R U L I N G B R I TA N N I A

PRODUCTIVITY PUZZLEUK productivity is poor. Hourly output was 17 percentage points below the G7 average in 2013, the widest productivity gap since 1992, according to the Office for National Statistics. This matters for debt dynamics. The UK has a small output gap (the difference between actual and potential GDP) that is set to disappear over the next year or so, the Office for Budget Responsibility (OBR) estimates. Suppose productivity stays weak, reducing the economy’s potential growth rate and shutting the output gap sooner? The UK would start to look like a structural borrower – vulnerable to punishment by bond investors. Improved productivity, by contrast, would delay the point of full capacity and comfort debt holders.

PRODUCTIVE BUDGETINGProductivity growth also holds the key to the UK’s budget deficit problems. The UK public sector’s borrowing requirements could range anywhere from +2% to -4.4% of GDP in fiscal 2019/20, depending on the path of productivity and real wage growth, the OBR estimates.

UK productivity is set to grow 1.8% annually over the next five years, the OBR’s central forecast assumes. This would help raise both real (inflation-adjusted) wages and tax revenues, allowing the government to reduce the deficit with less reliance on spending cuts. See the chart below.

How likely is this? We are sceptical. Productivity growth has averaged just 0.5% a year since 2008. Productivity growth has slowed to a crawl in countries such as Germany as well. At this pace, public sector net borrowing will total 2% of GDP by 2019-2020, the OBR estimates. See the ‘weak productivity scenario’ line in the chart.

Wage growth is critical. A 1% rise in average earnings boosts tax receipts by 1.5%, the OBR estimates, compared with 1% for every 1% growth in employment.

Conclusion: The success of any fiscal plan is highly dependent on productivity and wage growth trends.

SAME ENDS, DIFFERENT MEANSKey fiscal policy prescriptions of main parties

Labour Conservatives

Pub

lic fi

nanc

es

Structural budget deficit

Eliminate by 2017/18 Eliminate by 2017/18

Overall budget deficit

Aim to halve Eliminate by 2018/19

How to cut structural deficit?

50/50 tax and spending cuts 100% spending cuts

Net debt falling by…

2017/18 2015/16

Gov

ernm

ent e

xpen

ditu

res

Health

Ring-fenced Ring-fenced

Education

Ring-fenced and support for high-end apprenticeships. Cap university tuition fees

Ring-fenced, but not in real terms

Other social spending

Living wage paid by government Cap benefits

Pension

Ring-fenced, but recognising the need to increase the

retirement age in the futureRing-fenced

Energy

Cut fuel subsidy for rich pensioners. Cut energy bills

Freeze fuel duty

Gov

ernm

ent r

even

ues Income tax

Top income tax to 50%, from 45%. Tax bank bonuses.

10% lower starting tax rate

Raise top rate threshold to £50,000.

Raise personal allowance

Other tax

Tax properties valued at more than £2 million.

Withdraw pension tax relief for high earners

–

A MATTER OF PRODUCTIVITYUK public sector net borrowing, 2008-2020

-6

0

6

12%

2019-202016-172014-152012-132010-112008-09

SH

AR

E O

F G

DP

Actual

Weak productivity scenario

Strong productivity scenario

Central forecast

Sources: BlackRock Investment Institute and Office for Budget Responsibility (OBR), December 2014. Notes: OBR forecasts incorporate the impact of tax and spending measures announced by the current government. In the weak productivity scenario, growth in annual productivity remains at 0.5% – the average growth rate since 2008. In the central forecast, productivity gradually rises to 2% a year in 2019. The strong productivity scenario has productivity growing in line with the 3-4% rates of the 1970s and early 1980s.

“ The main parties are not too far apart on fiscal targets, so we don’t see long-term fiscal or bond market implications.”

– Tanja BoskovicSovereign Credit Analyst,

BlackRock Global Fixed Income

U K 2 0 15 E L E C T I O N P R E V I E W [ 7 ]

Taxes and cutsIf history is a guide, UK voters should brace for higher taxes in the year ahead. New governments tend to front-load unpopular measures such as tax increases and spending cuts early in their terms. All UK governments since 1992 raised taxes by at least £5 billion (in current prices) in their first year of office, according to the Institute of Fiscal Studies (IFS).

This contributes to a familiar pattern. Consumer confidence has historically risen in the months leading up to UK elections, but starts to fall in the months after, an analysis of elections since 1983 shows.

Why? The new government tightens spending. See the ‘election average’ grey line in the chart to the right. The lead-up to the current election is following the same script, with consumer confidence on the rise (the purple ‘2015’ line).

How necessary is the belt tightening? The UK government’s share of the economy is about average in the industrialised world, while its budget deficit is on the high end. France, Italy and Germany have a much larger government presence in the economy than the UK, whereas the US and Japan are on the opposite end. See the chart below.

The Organisation for Economic Co-operation and Development (OECD) projects average deficits of 3.4% of GDP for its 34 members in 2015, versus 4.4% for the UK.

This essentially means the UK has the potential to go either way – reduce or enlarge the government presence – as long as it whittles down the budget deficit.

READING THE TAX LEAVESWhere might the burden of tax hikes fall this time? Labour would reintroduce a 50% income tax top rate, from 45% now. Conservatives, by contrast, want to raise the threshold for 40% tax to annual incomes over £50,000. We suspect Labour and the Liberal Democrats (and the SNP) may favour increasing capital gains taxes.

Labour appears to have ruled out raising employer and employee National Insurance Contributions (NIC). A 1% rise in NIC would have brought in £4.9 billion in a full year, according to IFS. Conservatives plan to increase NIC thresholds. This would boost after-tax incomes and decrease tax revenues.

The recently enacted drop in corporation tax could be rolled back in favour of reduced rates for small- and medium-sized enterprises. And two Labour proposals on taxing financial services bear watching:

1. Transactions in UK equities between market makers have long been exempted from stamp duty. This is essential for the efficient functioning of capital markets, we believe. Yet the exemption allows investors to take synthetic exposure to UK equities without paying the tax. We expect this loophole to be tightened. The result could be higher bid-ask spreads and increased volatility.

2. Labour is set to reintroduce a recently scrapped stamp duty on UK unit trusts. This would raise investing costs and restore the competitive advantage of comparable funds domiciled in Ireland and Luxembourg.

AVERAGE GOVERNMENTSelected government expenditures and receipts, 2015

0 25 50%

US

Japan

Australia

OECD Average

UK

Germany

Italy

France

SHARE OF GDP

Expenditures Receipts

Sources: BlackRock Investment Institute and OECD Economic Outlook, December 2014. Note: the calculation is based on total general government outlays versus total tax and non-tax receipts.

ELECTION HANGOVERUK consumer confidence around elections, 1983-2015

-20

-15

-10

-5

0

5

2010

Election average since 1983

2015

-24-24 -18 -12 0 6 12 18-6 24

CO

NFI

DE

NC

E IN

DE

X

MONTHS BEFORE / AFTER ELECTION

Sources: BlackRock Investment Institute and GFK, February 2015.Note: the confidence index is rebased to zero in the month of each election and in the latest month for 2015.

[ 8 ] R U L I N G B R I TA N N I A

SPENDING CUTSWhat about the outlook for government spending? All parties agree the National Health Service (NHS), schools, pensioner rights and overseas development assistance are off limits for spending cuts.

Spending on NHS and Social Security is likely to keep increasing as the population ages. No party has detailed proposals for expenditure cuts after 2016/17. This is partly due to politics: flagging controversial spending cuts ahead of elections can be political suicide. In addition, the low-hanging fruit has already been picked. ‘Non-protected’ areas such as spending on defence, transport, Home Office and local authorities have already seen hefty cuts in the current parliament.

INFLATION CREEPThe new government will face rising fiscal challenges:

}Public sector pay demands have been subdued in recent years – but could increase if private sector wages keep rising in real terms. This would pressure public finances and might trigger earlier-than-expected rate rises. See the chart below.

}Falling interest rates alleviated debt servicing during the current parliament, while low inflation helped limit rises in social security spending (which is indexed to inflation). This Goldilocks scenario cannot last forever. We expect the BoE to raise rates before year end, and gilt yields to edge up accordingly.

}Some expenditures can be cut by stealth via ‘inflation creep.’ Real (inflation-adjusted) spending falls over time if you hold nominal outlays stable. This is harder to achieve if inflation stays low.

A REAL PAY RISE?UK wage growth, inflation and central bank rate, 2001-2015

0

2

4

6%

20152013201120092007200520032001

BoE base rate

Core CPI inflation

Wage growth

Sources: BlackRock Investment Institute and Office for National Statistics, February 2015.

SAVING SAVINGSFiscal pressures and politics could combine to reduce the attractions of many tax-advantaged savings structures – and hurt pension contributions.

The major parties appear to agree on curbing tax relief for pension contributions by highly paid workers. These claimed some 70% of £35 billion in total pension tax relief in 2013/14 , according to Morgan Stanley. A cut of several billion pounds looks likely, with a flat relief rate for contributions and/or a lower cap on the size of the pension pot.

We advocate any savings be re-invested into pensions and used to boost retirement savings for low- and middle-income families. Increasing this (large) group’s savings should reduce dependency on the state, save taxpayer money and help increase retirees’ consumption.

Auto-enrolment in pension schemes already incorporates contribution increases that progressively move people to higher savings levels. Yet the current staging involves a huge increase in employee contributions over a 13-month period between 2017 and 2018. This risks people opting out. It also fails to encourage contributions above 4% of salary.

The introduction of so-called auto-escalation could help smooth the journey. Employees would agree to add a portion of future salary increases to their pension contributions. For instance, they could agree to allocate 1% of any salary rise to increase their pension contributions to a maximum 8% of salary. The approach uses ‘nudge’ principles: people are better at making commitments in the future than in the present and will not miss a portion of a salary they have yet to receive.

We would support scrapping the lifetime limits on the value of pension pots in defined contribution pension schemes. There should simply be a limit on annual contributions instead. This would create certainty for those who might otherwise refrain from maximising the growth of their retirement savings due to concerns about hitting limits on the value of their savings at retirement. ‘Use-it-or-lose-it’ annual limits, by contrast, would provide the government with a mechanism to encourage (we hope) or limit savings.

Individual Savings Accounts (ISAs) have been a great success. The reason? Their simplicity. There have been murmurings of implementing a lifetime allowance or charging capital gains tax on realisations above an overall cap. Bad ideas, in our view. This would penalise individuals who have chosen successful long-term savings strategies.

U K 2 0 15 E L E C T I O N P R E V I E W [ 9 ]

InvestmentsThe fiscal credibility of a new government will loom large for the gilt market. The major political parties have slightly different policies, timeframes and ultimate targets for deficit reduction, yet they are all seeking to reduce the deficit (the SNP is the exception). The big picture, therefore, is slower growth in the issuance of gilts.

The gilt market has priced in little fiscal risk premium since the 2010 election and the height of the Eurozone sovereign debt crisis in 2011 (when the credit risk of Germany was similarly rising). See the chart to the right. The cost of insuring against default has been very low and stable in recent years, as economic growth has picked up and the deficit has been gradually falling.

Yet volatility spikes can be fast and furious. Could markets be too complacent? We think so. We do not see the election posing long-lasting credit risk to owners of UK sovereign debt – but we do brace for volatility in the short term.

A weak minority/coalition government (or a government that drifts from fiscal pledges) may lead the bond market to question the speed of falling gilt supply. Issuance expectations could rise moderately, leading buyers to demand higher risk premia on long-dated bonds.

Strong economic growth led by rising real wages and productivity (rather than property values and corporate spending) could help offset any fiscal slippage. This would boost tax revenues and reduce gilt issuance. Yet we would expect to see any weak government trigger a further steepening of the UK yield curve. Long-dated gilts would cheapen relative to shorter-dated debt. The premium baked into inflation-linked gilts would also likely rise.

PERFORMANCE IMPROVEMENT? UK credit markets have underperformed global markets over the past year, partly due to uncertainty around the election outcome. This underperformance could start to reverse after the election (assuming a stable result) as European investors look for alternatives to the rock-bottom yields at home. UK yields look attractive compared with German ones. See the table below.

Some corporate bond sectors could be at risk depending on the election outcome – particularly those in highly regulated industries such as utilities and banking (see page 11).

“ This election is a short-term, temporary risk event for the gilt market. Domestic structural demand should act as a floor for any weakness.”

– David CurtinPortfolio Manager,

BlackRock Sterling Fixed Income

A LOW-YIELD WORLDUK, German and US fixed income yields and valuations, March 2015

2-year government 10-year 30-year Corporate credit

Yield15-year

percentile Yield15-year

percentile Yield15-year

percentileSpread

(basis points)15-year

percentile

UK 0.4% 92% 1.5% 100% 2.3% 100% 132 48%

Germany -0.2% 100% 0.2% 100% 0.6% 100% 99 51%

US 0.6% 73% 1.9% 92% 2.5% 99% 130 64%

Sources: BlackRock Investment Institute, Thomson Reuters and Barclays, 25 March 2015. Notes: percentiles show valuations versus their historic ranges in the period 2000 to 2015. Example: if an asset is in the 75th percentile, this means it has a valuation equal to or greater than 75% of its history.

THE COST OF INSURANCEFive-year credit default swap spreads, 2008-2015

0

50

100

150

2008 2009 2010 2011 2012 2013 2014 2015

2010 election

UK

US

Germany

BA

SIS

PO

INTS

Sources: BlackRock Investment Institute and GFK, February 2015.

[ 1 0 ] R U L I N G B R I TA N N I A

FOREIGN CLOUT Demand from overseas investors may temporarily decline if the election outcome is uncertain or results in a weak government. Foreigners own 28% of outstanding gilts. See the chart to the right. This could pressure short- and medium-dated gilts (where overseas participation is more pronounced), and slow down foreign direct investment. Possible result: a weaker currency because the current account deficit needs to be financed by foreign inflows.

Should UK pension schemes cut their exposure to gilts to diversify their risk exposure? We do not think so. Overseas assets can provide income to enhance low-yielding UK gilts. Yet reducing gilt exposure increases the sensitivity of pension scheme funding to interest rate movements. And hedging is set to become more expensive as US rates rise.

The impact of foreign investors may be waning anyway. UK domestic investors digested the bulk of gilt issuance over the past year. See the chart below. They should remain a steady source of demand as supply is likely to shrink further.

The UK, like other developed nations, has mounting fiscal liabilities. These include unfunded public pensions, nuclear decommissioning costs and the fiscal burden of an ageing population. Yet these are slow-burning risks. A shortage of high-quality fixed income and a steady appetite for yield from long-term asset owners should provide a steady bid for gilts, dampening any yield spikes for now.

HER MAJESTY’S CREDITORSUK gilt ownership, 2000-2014

0

25

50

75

100%

20142012201020082006200420022000

Bank of EnglandOther

Banks

Insurance and pensions

Overseas

SH

AR

E

Sources: BlackRock Investment Institute and UK Debt Management Office, February 2015. Note: banks include other financial institutions such as brokerages.

A CHANGE IN BUYERSNet issuance and changes in UK gilt holdings, 2006-2015

-50

0

100

£200

201420132012201120102009200820072006

BIL

LIO

NS

Overseas

Insurance and pensions

Banks

Bank of England

Total

Sources: BlackRock Investment Institute, Bank of England and UK Debt Management Office, February 2015. Notes: the bars show cumulative issuance and change in holdings in each year. Banks include other financial institutions.

POLITICS AND PROPERTY Election uncertainty could temporarily sap the UK property market’s strength as tenants and developers defer major decisions until a government is formed. This effect should be fleeting.

Fiscal austerity proposed by the Conservatives would likely hit areas outside the affluent South East because government spending underpins a much greater share of employment there. The party’s plans to make Manchester into a ‘Northern powerhouse’ may partially offset this.

Labour’s proposed ‘mansion tax’ on high-value residential properties would mostly affect central London, a sector few institutional investors are invested in. Plans by Labour and Liberal Democrats to boost government spending would support regional markets. Yet this could come at the cost of higher bond yields and mortgage rates.

Uncertainty surrounding the UK position within the EU could dent demand for office space from global companies in the long run. The greater the share of the vote obtained by UKIP and the Conservatives, the greater the impact.

“ We don’t see long-run implications for the way UK pension schemes should manage their assets.”

– John DeweySenior Strategist,

BlackRock Solutions Client Strategy

U K 2 0 15 E L E C T I O N P R E V I E W [ 1 1 ]

ELECTIONS AND EQUITIESSmaller companies are likely more vulnerable to a dip in consumer confidence after the election. UK small cap equities rely on the domestic economy for 71% of their sales, compared with just 24% for large caps. See the table below. Election risks differ by sector:

Utilities (generally dislike): pressure to lower prices

}Labour is committed to a 20-month freeze in retail tariffs for electricity and gas supply. This would curb returns, limit dividends and trigger rating downgrades – cushioned partly by the fall in oil prices.

}Labour has also talked of windfall profit taxes. Greens want to increase the costs of power generation.

Banks (stock selection is key): Brexit and Labour fears

}The Conservatives-led government raised banks’ effective tax rate and hiked the bank levy in the March budget. A possible Brexit referendum could threaten London’s role as a European financial centre.

}Labour proposes to cap bank market shares, create ‘sizeable and competitive’ challenger banks and increase the levy.

Bus and rail (generally dislike): changes under Labour

}Government-backed bidders could join the rail franchising process under a Labour-led government, hurting private operators. Re-nationalisation is a remote possibility.

}Bus operators face the risk of subsidy cuts – although parties have not yet announced plans.

Retail (stock selection is key): multiple challenges

}A repeat of the usual post-election drop in consumer confidence could result in underperformance.

}Labour could increase the minimum wage, hitting profitability. A weaker pound would raise import costs.

House builders (generally like): broad support

}Schemes such as ‘help to buy’ could be extended. Increased supply of housing is likely, with Labour talking about a target of 200,000 new homes a year.

}A negative: Labour’s mansion tax (bad for London builders) and talk of taxing land ‘hoarded’ by developers.

GOOD CORPORATE CITIZENS We are fervent supporters of the UK Stewardship Code. Its flexible, principles-based approach fosters constructive engagement between shareholders and companies. The code also raises the corporate governance bar as it is continually updated and improved.

One hot-button issue has been executive pay. Political parties support alignment between compensation and long-term performance. Disclosure and transparency of pay arrangements are key to make this a reality. Poor remuneration practices tend to reflect poor corporate governance.

Governance mechanisms around pay should not be made more onerous, however. The binding ‘say on pay’ has focused engagement on reviewing remuneration ahead of shareholder votes – and away from factors critical to corporate success (board composition, capital allocation and strategy).

Proposals for employee representation on remuneration committees are misguided, we believe. Successful companies tend to have expert boards with accountability to shareholders. Shareholders provide capital and bear the risk of loss, giving them the right to appoint boards.

“ There is unity among the parties about the need to increase housing. House builders also have newfound discipline on margins and capital management.” – Nick Osborne

Portfolio Manager, BlackRock UK Equity

EXAMINING EQUITIESUK, eurozone and US equity markets comparison, March 2015

Valuation Exposure Performance Volatility

Forward P/E

15-year percentile

Dividend yield

15-year percentile

Domestic revenues

Year-to-date 12-months

3-month volatility

15-year percentile

FTSE 100 large cap 15.2 66% 3.4% 58% 24% 7.5% 9.7% 11.3% 33%

FTSE 250 mid cap 16.2 93% 2.5% 77% 53% 9.1% 11.3% 8.1% 14%

FTSE small cap 13.5 44% 2.4% 58% 71% 6.7% 6.4% 4.7% 9%

Euro Stoxx 16 85% 2.7% 42% 58% 18.2% 22.9% 12.8% 24%

S&P 500 17 78% 2% 33% 74% 0.6% 12.8% 12% 35%

Sources: BlackRock Investment Institute and Thomson Reuters, 25 March 2015. Notes: The percentiles show current asset valuations versus their 15-year history. Example: an asset in the 75th percentile has a valuation equal to or greater than 75% of the period 2000 to 2015. Low dividend yields indicate high valuations, and vice versa. Index performance is in local currency. Index performance is shown for illustrative purposes only. It is not possible to invest directly in an index. Past performance is not indicative of future returns.

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This material is part of a series prepared by the BlackRock Investment Institute and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 2015 and may change as subsequent conditions vary. The information and opinions contained in this paper are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This paper may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this paper is at the sole discretion of the reader.

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