Equity investors reject UK election risk

Political stakes seldom come higher than they do in next month's UK general election. And the range of choices facing the electorate is seldom so wide.

Among the possible outcomes of next month's general election are the following: a commitment to a referendum on the EU that could quite conceivably see the UK vote to leave; a new prime minister (Labour's Ed Miliband) who would represent the biggest departure from the post-Thatcherite economic consensus in decades; a pivotal role in government for a party (the Scottish Nationalists) devoted to splitting up the UK; and a chaotic minority government attempting to rule vote by vote, always facing the risk of a collapse and an impromptu election

The UK political system is not designed to deal with such a range of options. For two centuries, it has almost uninterruptedly enjoyed majority governments and a two-party system. This situation is unprecedented. There are few if any "market-friendly" outcomes. And the old cliche is quite right that markets hate nothing like uncertainty.

Why, then, the air of apparent calm? The election campaign has not much excited the voters so far (outside Scotland at least). And as for stock markets, the FTSE 100 has been setting all-time highs. At first glance, then, it appears that UK investors are worryingly blase.

A closer look reveals that some uncertainty has now been cooked into prices. The FTSE 100 is dominated by multinationals. The FTSE 250 index of smaller companies is more sensitive to Westminster, and is 5 per cent below its level of a year ago. Then, compare with other countries. Using Datastream indices, Ian Harnett of Absolute Strategy Research shows that UK stocks are their cheapest relative to the rest of the world in 25 years. This suggests that the UK does have some cushion from valuation, should its politics go haywire.

Then, look at the currency. Sterling has enjoyed a period of strength in the post-crisis QE environment, driven by differentials in yields. Analysts expect the Bank of England to be among the first central banks to start raising rates again, and this has supported sterling.

For a while, sterling has moved directly in line with rate differentials. In the past few weeks it has veered sharply from that course. David Bloom, head of foreign exchange research at HSBC, now estimates the electoral "discount" at about 6 per cent. Without the political worries, he suspects, sterling would trade at $1.55; it is currently below $1.50.

There are other signs of concern. The options market shows investors building protection against a spike in volatility after the election. In the gilts market, international investors have reduced their holdings by $14bn so far this year. With the deficit, presumably linked to the UK's ability to repay its debt, one of the central issues in the campaign, this makes sense - even if low bond yields still make clear that nobody seriously questions the UK's creditworthiness.

Add this together and enough uncertainty is written in to markets to mean that UK equities and bonds are not at this point a clear-cut "sell". But it would be foolhardy to try buying until the uncertainty has been resolved, probably after the election.

At that point, however, the evidence of 2010 - when the UK had its first brief taste of political horse-trading after an inconclusive election - is that there might be a nice buying opportunity.

On that occasion the Conservatives and Liberal Democrats thrashed out their coalition by May 11, and sterling bottomed on May 20 before starting a rally. The FTSE 250 fell for a little longer, hit bottom on July 1 and subsequently more than doubled (in dollar terms).

What exactly scares the market the most, and what would relieve the uncertainty? Plainly most investors would be far more comfortable with a right-of-centre government. The Miliband rhetoric is not market-friendly.

Many analysts say that a Labour government propped up by the Scottish Nationalists (more vehemently opposed to austerity policies than is Labour) in some formal or informal way would be worse still.

The problem with a fresh Conservative government is that it could come with a commitment to a referendum on EU membership, and the real possibility of exit. This would particularly be the case if the anti-EU UK Independence party held the balance of power, and could be toxic as far as international investors are concerned.

So the worst market outcomes would see weak governments beholden to more extreme parties.

Democracy is a wonderful thing, and investors have to live with it. But the ideal market outcome may well be something the polls suggest few voters want: another stable coalition with the centrist Liberal Democrats in power. It is obvious from the polling numbers that few British voters feel happy with the past five years, but the period has worked out well for markets.

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