UK election risk hovers on horizon for markets

When the UK last held a national election in May 2010, Stephanie Flanders, then a BBC journalist, was sent to report on market reaction to the indecisive result and frantic coalition talks in Westminster. Much to her editors' disappointment, she failed to find much drama in the City of London. "I had to report to them that there was no panic at all," she recalled this week.

Five years later, will the drama be any greater? Some signs are emerging that this year's election could be more compelling for UK markets. With opinion polls pointing to another close result, the cost of insuring against sterling volatility in a month's time - immediately after the May 7 poll - rose on Thursday to levels not seen in at least four years.

The surge followed a warning last week from BlackRock, the world's largest asset management company, that markets were being "too complacent" in expecting a "smooth and swift government handover". While the formation of a new government can take weeks elsewhere in Europe, such delays remained "unusual and somewhat harrowing for the UK," it cautioned in a report.

"A soothing outcome for markets is hard to imagine," BlackRock added.

Even if the election creates risks for investors, however, sharp market movements are not inevitable. "Tail risk" events such as "Brexit" - a UK exit from the EU - that would create turmoil but seem unlikely to happen are easier for markets to ignore when there are a host of other more immediate global concerns.

Back in May 2010, the eurozone debt crisis was at its height and UK assets benefited from the country's haven status. This year as well, "there is bigger stuff happening," says Ms Flanders, now chief market strategist for Europe at JPMorgan Asset Management.

While the UK has large fiscal and current account deficits, the forces most affecting sterling's value, as well as UK bond and equity prices, are global - most obviously, US and eurozone monetary policies, which are creating transatlantic interest rate divergences. As a result, events in Washington and Frankfurt or in geopolitical hotspots such as the Middle East or Ukraine are higher on the minds of international investors.

"In conversations with global clients, it's clear that they are aware of the [British] issues, but the point they keep making is that there are a lot of problems in the world and the UK elections come a long way down the list," says Andrew Milligan, head of global strategy at Standard Life Investments.

UK credit default swap prices - the cost of insuring against a UK default - remain subdued. Sterling exchange rates are a more obvious expression of global perceptions about the UK. But even in foreign exchange markets, the reaction ahead of the May 7 poll has so far been limited.

This week's surge in one-month sterling volatility was largely a calendar effect, says Peter Kinsella, senior foreign exchange strategist at Commerzbank. "The back end of the curve - expectations about volatility in one or two years' time - remains remarkably sanguine. The market is pretty relaxed about a possible Brexit risk."

Reaction across the equity and bond markets could also remain subdued, investment strategists believe. Guy Ellison, head of UK equity research at Investec Wealth & Investment, says: "Clearly the outcome of the election is uncertain, and markets don't like uncertainty." But the jitters, he reckons, will be largely in currency markets.

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On the other hand, sterling weakness would help many of the large multinational companies that populate the FTSE 100 index.

"To a degree, that's an insulating factor," says Mr Ellison.

Similarly, in gilt markets, there is little evidence that investors have become noticeably more worried recently about the UK's large fiscal deficit. "The tail risk of a Labour-led coalition backtracking on fiscal commitments should translate into a slightly higher sovereign risk premium, if for no other reason that there will be a greater supply of gilts," argues Joe Di Censo, fixed income portfolio manager at BlackRock. However, he adds that the likely impact is "ambiguous" because much would depend on the relative attraction of UK gilts versus low-yielding eurozone bonds.

But Michael Riddell, fund manager at M&G Investments, says: "I struggle to see how the market is underpricing election risks . . . You could even argue that a Labour victory would, if anything, be bond market friendly given it will mean a substantially lower chance of the UK leaving the EU in the next parliament . . . As a bond investor, I'm not overly worried by this coming election."

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