Markets are worrying about the wrong thing in British election

This week's UK general election looks unlikely to deliver an overwhelming victory for either the Conservatives or the opposition Labour party - which leaves financial market participants unsure of what political climate they will be facing .

But those preoccupied with the implications of the parties' differing policies on the economy and EU membership may well be worried about the wrong thing. More important, but less appreciated, are the distinct approaches of the main parties - and their allies in any coalition - towards a financial services industry that has yet to restore its credibility after the global crisis.

Conservative and Labour manifestos propose discrete policies for economic management; yet their ability to implement them is subject to considerable political and economic constraint.

With neither party set for a big majority, there is limited scope for radical policy shifts. Neither will wish to put at risk a recovery that is impressive on job creation but, judging from last week's gross domestic product data, yet to develop secure roots. It is likely the existing approach will be tweaked, with easing of austerity and marginal structural measures to boost productivity and growth.

In the absence of an ex­treme partnership involving the Scottish National party or the UK Independence party, the two main parties would probably follow similar approaches to immigration and foreign policy - at least, alike enough for financial markets. The gap appears larger when it comes to the EU.

As the Tories promise a referendum on staying in Europe, a win for them would initially bring greater uncertainty. By undermining UK companies' access to such a large market, an exit would weaken profits. Equities would underperform while bond spreads would widen as markets price in higher volatility risk. Yet it is unlikely that a vote would lead to an exit. It would probably take place after a re-elected Prime Minister David Cameron had secured concessions from fellow European leaders - not enough materially to alter the functioning of the single market but sufficient for the Tories to join other parties in urging continued membership. In such circumstances, UK voters are likely to choose staying in.

Indeed, the biggest likely difference, and the one with the greatest potential financial market impact, lies elsewhere.

A Labour government would take a less lenient approach to financial services that are still not widely trusted. It would be more open to tighter regulation, pay limits and pursuing high-profile legal cases. It would engage in spirited debate with companies threatening, like HSBC, to move their headquarters from the UK, and would be less inclined to fight off EU regulation.

With the sector shrinking as a result, markets would price in higher risk premiums for bonds and equities on account of a possible fall in liquidity levels - that is, tighter constraints on broker-dealers assuming significant counter-cyclical risk as end investors react to changes to fundamentals elsewhere.

Such an adjustment could be pronounced. Steps to boost growth and validate high financial asset prices, including infrastructure investment and tax reform, would then be needed. The alternative is asset prices that converge to the lower fundamentals, overshoot them and risk contaminating the general economy.

So markets should put worries about traditional questions on the economy and the EU to one side and turn their focus instead to guarding against the gross underpricing of liquidity risk.

The writer is chief economic adviser to Allianz and chair of US President Barack Obama's Global Development Council

© The Financial Times Limited 2015. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation